Understanding scenario analysis
In sensitivity analysis, we have selected a few inputs/drivers and changed them while keeping all other variables the same. This has shown us the isolated effect that each of the selected inputs has on the share price. However, in practice, this is rarely the case. Variables do not change in isolation. What you generally have is a number of variables changing as a result of a certain set of circumstances or a scenario.
Scenario analysis usually looks at two or three sets of circumstances, most likely, worst-case and best-case scenarios. For each scenario, you would assume alternative values for selected variables. In selecting the variables, you would concentrate on those inputs or drivers that are the most subjective. Scenario analysis involves substituting all the selected variables for a given scenario in your model and examining the effect this has on the share price.
