How does scenario analysis differ from sensitivity analysis in DCF valuation, and how do analysts construct bull/base/bear cases?

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AcadiFi · Accepted Answer

Scenario analysis and sensitivity analysis are complementary but distinct valuation tools. While sensitivity analysis isolates the impact of individual variables, scenario analysis constructs internally consistent sets of assumptions that reflect plausible future states of the world. **Key Distinction** Sensitivity analysis asks: "What happens to value if WACC changes by 50 bps, holding everything else constant?" Scenario analysis asks: "What does the company look like in a recession versus a boom, with all relevant variables adjusted together?" **Scenario Construction Framework** Each scenario should represent a coherent narrative where assumptions are logically linked: **Worked Example — Bridgewater Consumer Brands:** | Assumption | Bear Case | Base Case | Bull Case | |---|---|---|---| | Revenue CAGR (5yr) | 2.0% | 6.5% | 11.0% | | EBITDA Margin (Year 5) | 14.0% | 17.5% | 21.0% | | Capex/Revenue | 7.0% | 5.5% | 5.0% | | Terminal Growth | 1.5% | 3.0% | 4.0% | | WACC | 10.5% | 9.0% | 8.0% | | Working Capital Days Change | +5 days | 0 days | -3 days | **Narrative Behind Each Scenario:** - **Bear** — Economic slowdown, private label penetration rises, input cost inflation compresses margins, credit spreads widen increasing cost of capital - **Base** — Moderate GDP growth, stable market share, operating leverage from scale, normalized capital markets - **Bull** — Successful product innovation, emerging market expansion, digital channel growth reduces distribution costs, risk premiums compress **Resulting Valuations:** | Scenario | Enterprise Value | Equity Value/Share | Probability Weight | |---|---|---|---| | Bear | $4.2B | $32.50 | 25% | | Base | $6.8B | $54.20 | 50% | | Bull | $10.1B | $82.70 | 25% | **Probability-Weighted Target Price:** (0.25 x $32.50) + (0.50 x $54.20) + (0.25 x $82.70) = $8.13 + $27.10 + $20.68 = **$55.91** \`\`\`mermaid flowchart TD A["Define Macro &
Industry Outlook"] --> B["Bear: Recession
Margin Compression"] A --> C["Base: Moderate
Growth"] A --> D["Bull: Expansion
Market Share Gains"] B --> E["Internally Consistent
Assumptions"] C --> F["Internally Consistent
Assumptions"] D --> G["Internally Consistent
Assumptions"] E --> H["DCF: $32.50"] F --> I["DCF: $54.20"] G --> J["DCF: $82.70"] H --> K["Assign Probabilities
& Weight"] I --> K J --> K K --> L["Target Price
$55.91"] \`\`\` **Common Mistakes to Avoid:** 1. **Inconsistent assumptions** — A bear case with high revenue growth but compressed margins is internally contradictory unless there is a specific story (like predatory pricing) 2. **Symmetric probability weights** — There is no requirement that bear and bull carry equal weights; calibrate based on the current macro environment 3. **Ignoring second-order effects** — A recession scenario should also affect working capital, default risk, and potentially the share count through buyback cessation 4. **Too narrow a range** — If the bear and bull cases are within 20% of base, the scenarios are not exploring enough tail risk Scenario analysis is particularly valuable for companies facing binary catalysts like regulatory decisions, patent expirations, or M&A outcomes. Master scenario construction in our CFA Level II Equity Valuation course.

How does scenario analysis differ from sensitivity analysis in DCF valuation, and how do analysts construct bull/base/bear cases?

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