Valuation through scenario analysis

valuation through scenario analysisWhen we analyze companies in which to invest, in many cases we must deal with situations of uncertainty in which there are different hypothetical cases that can occur with different probabilities. To analyze this type of company, the use of valuation through scenario analysis is an appropriate resource. In this article we will see what valuation through scenario analysis consists of, when to use it, its advantages, and an example of valuation using this method.

What is valuation through scenario analysis?

Assessment by scenario analysis consists of assessing the result of different hypothetical situations, giving one of them different probabilities. The total assessment will be the result of weighing each situation in relation to the probability that it will occur in the future. This type of valuation is framed within the valuation through real options, which we already talked about on this website in the article on what valuation method to use to analyze stocks.

When to use valuation through scenario analysis?

In situations of uncertainty, such as possible takeover bids, turnarounds or research results in R + D + i. Also in companies with an uncertain future, exposed to great changes in the future.

Advantages of using valuation through scenario analysis

Valuation through scenario analysis is a simple method to value companies in times of uncertainty without having to resort to more complex alternatives such as Black-Scholes model of option pricing.

Example of valuation using scenario analysis

We are going to see an exaggeratedly simple example in order to see how the valuation works through the analysis of scenarios. The real cases are more complex, but this example serves to get an idea.

The company Construcciones Paco SA, which is in crisis, is gambling its future only on a card, the award of a work to build the AVE that runs from A Coruña to Irún. For this, the company invests all its capital to obtain the work. If it finally succeeds, it will obtain a net profit of 500 million euros, after which it will be dissolved and delivered to its shareholders tax-free. The probability of achieving the award of the work is 50%. How much is the company worth through scenario analysis?

1 scenario:

  • Probability: 50%
  • Company value: € 0

2 scenario:

  • Probability: 50%
  • Company value: 500 million euros

Company value:

  • 0 * (50%) + 500 * (50%) = 250 million euros

I hope that this short summary will help you to start your assessment by analyzing scenarios. If it has not been clear, you can share any questions in the comments and I will answer them as soon as possible.