How can scenario analysis help you evaluate risk and return trade-offs?

1 What is scenario analysis?

Scenario analysis is a method of projecting the future performance of a project or investment under different sets of assumptions and conditions. It helps to assess the impact of uncertainty and risk on expected returns, as well as explore the range of possible outcomes and their probabilities. This technique can be used for various purposes, including testing the feasibility and viability of a product, market, or strategy; evaluating the effects of external factors, such as market demand, competition, regulations, or technology; planning for contingencies and mitigating risks; and communicating and presenting your analysis and recommendations to stakeholders.

2 How to identify key drivers and uncertainties?

The first step in scenario analysis is to identify the key drivers and uncertainties that affect your project or investment. These variables have the most influence on your cash flows, profitability, and value, and are subject to change or variation. Examples of key drivers and uncertainties include sales volume and growth rate, price and cost levels and margins, capital expenditures and working capital requirements, discount rate and cost of capital, and tax rate and inflation rate. To estimate the values and ranges of these variables, you can use various sources of information such as historical trends, industry reports, market research, expert opinions, or your own assumptions. Additionally, you should consider the interrelationships and dependencies among the variables and how they might vary across different scenarios.

3 How to build scenarios?

The next step in scenario analysis is to build scenarios based on your key drivers and uncertainties. A scenario is a set of assumptions and inputs that reflect a specific situation or condition. You should create at least three scenarios: a base case, a best case, and a worst case. The base case represents your most likely or expected outcome, based on your realistic and reasonable assumptions. The best case represents your most optimistic or favorable outcome, based on your high-end or positive assumptions. The worst case represents your most pessimistic or unfavorable outcome, based on your low-end or negative assumptions.

You can use spreadsheets or software to build your scenarios and calculate your outputs, such as cash flows, profitability, and value. You should use the same model or formula for all scenarios, but vary the inputs according to your assumptions. You should also document your assumptions and sources, and label your scenarios clearly.

4 How to analyze results and sensitivity?

The final step in scenario analysis is to analyze the results and sensitivity of each scenario. You should compare the outputs of your scenarios and identify the differences and implications. You should also calculate the expected value and the standard deviation of your outputs, which measure the average and the variability of your outcomes, respectively. The expected value is the weighted average of your outputs, where the weights are the probabilities of each scenario. The standard deviation is the square root of the weighted average of the squared deviations of your outputs from the expected value. A higher standard deviation indicates a higher risk or uncertainty.

You should also perform a sensitivity analysis, which shows how your outputs change when you change one or more of your inputs. You can use tables, charts, or graphs to display your sensitivity analysis, and highlight the key variables that have the most impact on your outputs. You should also test the robustness and validity of your scenarios and assumptions, and check for errors and inconsistencies.

5 How to make decisions and recommendations?

The final outcome of scenario analysis is to make decisions and recommendations based on your findings and objectives. You should use your scenarios and sensitivity analysis to evaluate the risk and return trade-offs of your project or investment, and to weigh the pros and cons of each option. You should also consider the qualitative and quantitative factors, such as strategic fit, competitive advantage, stakeholder interests, and ethical issues, that affect your decision and recommendation. You should present your analysis and recommendation in a clear and concise manner, and support them with evidence and logic. You should also acknowledge the limitations and uncertainties of your analysis, and suggest further steps or actions to improve or implement your recommendation.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?