How we can use sensitivity analysis by using DCF method for valuation of security and factors to be considered while using sensitivity analysis

Sensitivity analysis is a useful tool to evaluate the impact of changes in assumptions on the estimated value of a security using the DCF method. Here are the steps to perform sensitivity analysis using the DCF method:

Identify the key assumptions: The first step in sensitivity analysis is to identify the key assumptions used in the DCF model. These may include assumptions related to the cash flows, growth rate, discount rate, and terminal value. 

Determine the range of values: Once the key assumptions have been identified, it is important to determine a range of values for each assumption. For example, the range of values for the expected growth rate may be 0% to 10%. 

Calculate the estimated value: The next step is to calculate the estimated value of the security for each combination of values of the key assumptions. This will result in a range of estimated values for the security. 

Analyze the results: The results of the sensitivity analysis can be used to understand the impact of changes in the key assumptions on the estimated value of the security. For example, if the estimated value is highly sensitive to changes in the discount rate, this may indicate that the risk profile of the security is an important consideration in its valuation. 

Factors to consider while using sensitivity analysis: 

Range of values: The range of values used in the sensitivity analysis should be realistic and reflect the uncertainty surrounding the key assumptions. It is important to avoid using unrealistic or extreme values that do not reflect the true nature of the assumptions. 

Key assumptions: The sensitivity analysis should focus on the key assumptions that are most important for the valuation of the security. It is important to identify and focus on the assumptions that have the greatest impact on the estimated value. 

Level of detail: The sensitivity analysis should be performed at a level of detail that is appropriate for the complexity of the security being valued. For example, a more detailed analysis may be required for a complex security such as a real estate investment trust (REIT) than for a simple stock. Communication: The results of the sensitivity analysis should be communicated clearly to stakeholders. This includes explaining the methodology used, the range of values tested, and the implications of the results. 

In conclusion, sensitivity analysis is a useful tool to evaluate the impact of changes in assumptions on the estimated value of a security using the DCF method. Careful consideration of the key assumptions and range of values used in the analysis is important to ensure an accurate valuation. The results of the sensitivity analysis can be used to identify key drivers of the value and to highlight areas of uncertainty.