Every valuation model is based on a variety of assumptions about the future. And assumptions about the future by nature are uncertain. How will you account for the fact? How will you account for this uncertainty? You will account for this uncertainty by doing a sensitivity analysis. Sensitivity analysis is the process how evaluating how sensitive your valuation is for changes in assumptions.
Since the DCF valuation model relies on a large number of assumptions, which are the ones you will focus on? Using Crystal Ball or @Risk or a similar software enables you to do sensitivity analysis on many variables at a time.
How do you pick the top four – if you are using a data table approach to sensitivity analysis?
The top four variables you should do a sensitivity analysis on include revenue growth rates, EBIT margins, discount rate and the terminal value driver (terminal growth rate or exit multiple).
Other variables you could do a sensitivity analysis on when valuing a company using the DCF method can be categorized into the following buckets. Operating factors, terminal value drivers, discount rate factors.
- Operating factors that we can do a sensitivity analysis on include revenue growth rates, CoGS or gross margin, operating or EBIT margin, reinvestment rate, etc.
- Terminal value drivers that we can do a sensitivity analysis include the WACC, terminal growth rate primarily. If you are using the exit multiples method to estimate the terminal value, we will do a sensitivity on the exit multiple used.
- Discount rate factors that we can do a sensitivity analysis on include the WACC and cost of equity primarily. You can also look at the other drivers such as cost of debt, market risk premium and risk-free rate too.