Scenario analysis can be used in a variety of instances with the main goal of predicting the likely outcome of an event. People then use this prediction to make more informed choices in the present, though there is always the risk that the prediction won't come to fruition. This type of analysis is frequently used as a way to anticipate the value of an investment.
When to use Scenario Analysis
From small business owners to stock brokers to individuals, people interested in all different types of capital and industries use this type of analysis. Some investors do so without even realizing it. In its simplest form, investors conduct this type of analysis when they look at an investment opportunity and play out a series of possible outcomes to help them make a decision. As such, this analysis is helpful when doing things like buying stocks, looking to sell off or buy a business, or even when composing a personal budget. It helps the person or company better plan for a number of eventualities.
How to Conduct an Analysis
Scenario analysis is typically done by investors and companies, but can also be done on an individual level by following several steps:
1. Identify certain elements of the investment that will most certainly occur
2. Identify any variables related to these elements
3. Identify the variables and volatility in the market that could affect the investment
4. Consider several different possible outcomes for all variables
5. Determine what level of risk you're personally comfortable with undertaking.
These steps are explained in further detail below.
Variables When Looking into the Future
Attempting to predict the future can be a risky task, especially when it comes to finances, as there are a number of variables to be taken into consideration. For example, when investing in stocks it's wise to analyze the course that the stock has taken so far, as well as look at industry predictors for that stock. In the best case, the company has performed well in the past and created revenue for its shareholders. Additionally, it will be in an sector of the market that is relatively free of volatility. These are just a few variables to consider when conducting a scenario analysis; depending on the type of investment or expenditure there may be others.
Assess the Risk of These Variables
To identify variables in an investment or venture, look at the drivers that will be most likely to affect the rate of return. If acquiring a business, for example, the potential future owner should address things like cash on hand, cash flow, potential revenue, ways in which the company is under-performing or over-projecting, and any ways in which these areas can be tweaked or adjusted. Once the variables of the investment or venture are identified, business experts then recommend playing out them in the best-case, average-case and worse-case scenarios.
When investors have a better handle on the eventualities of risk, they will be more aware of whether or not they can manage the worst-case risk. Scenario analysis helps anticipate these risks so that making an investment doesn't have to be a gamble.