How do you choose the key drivers for sensitivity analysis in DCF? (2024)

Sensitivity analysis is a useful tool to test the impact of different assumptions on the value of a company or a project using discounted cash flow (DCF) valuation. By changing one or more variables, such as revenue growth, discount rate, or terminal value, you can see how the DCF value changes and how sensitive it is to those inputs. But how do you choose the key drivers for sensitivity analysis in DCF? In this article, we will discuss some criteria and examples to help you select the most relevant and realistic variables for your analysis.

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When choosing key drivers for sensitivity analysis in DCF, the first step is to identify the main sources of uncertainty and risk in your valuation model. These are the factors that have the most influence on the future cash flows and discount rate, and that are also subject to significant variability or estimation error. To make a selection, consider the level of historical or forecasted volatility of the variable, its correlation with cash flows or the discount rate, the availability and reliability of data and assumptions for the variable, and its relevance and materiality for the industry, market, or business model.

The choice of key drivers for sensitivity analysis in DCF may vary depending on the context and purpose of your valuation. However, some common key drivers are revenue growth, operating margin, discount rate, and terminal value. Revenue growth reflects the market size, demand, and competitive position of the company or project, while operating margin measures its profitability and efficiency. Discount rate reflects the required return or opportunity cost of investing in the company or project, while terminal value accounts for a significant portion of the DCF value. Factors that can affect these key drivers include price, volume, market share, product mix, customer retention, innovation, cost structure, economies of scale, pricing power, operational leverage, quality, risk-free rate, market risk premium, beta, cost of debt, capital structure, tax rate, growth rate, exit multiple and perpetuity method.

Once you have chosen the key drivers for sensitivity analysis in DCF, you need to decide how to perform the analysis. Scenario analysis, one-way sensitivity analysis, and two-way sensitivity analysis are all common methods. With scenario analysis, you create different scenarios based on different combinations of assumptions for the key drivers, such as base case, best case, and worst case. With one-way sensitivity analysis, you change one key driver at a time and hold all other variables constant. This helps to identify the most sensitive driver and the break-even point. With two-way sensitivity analysis, you change two key drivers at a time and hold all other variables constant. This allows you to analyze the interaction and trade-off between the two drivers.

To make your sensitivity analysis in DCF more effective and reliable, you should use reasonable and realistic ranges for the key drivers, based on historical data, industry benchmarks, or expert opinions. You should also use consistent and logical assumptions for the key drivers when creating different scenarios. It is beneficial to use multiple methods and tools for sensitivity analysis, such as Excel, financial calculators, or online software. Additionally, it is important to interpret and communicate your results clearly and transparently, emphasizing the main findings, implications, and limitations of your analysis. Finally, it is essential to avoid drawing definitive or absolute conclusions based on your analysis as it is only a tool to support your valuation and decision making.

Sensitivity analysis in DCF has many benefits and limitations that you should be aware of. It can help you understand the drivers and risks of your valuation, test the robustness and validity of your assumptions and model, explore different scenarios, evaluate their feasibility and attractiveness, and communicate and justify your valuation to stakeholders and investors. On the other hand, it can be time-consuming and complex, subjective and uncertain, misleading or inaccurate, or overused or misused if not done properly.

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DCF Valuation