DCF Sensitivity Analysis: Mastering Financial Modeling with Excel

Mastering financial modeling with Excel is a crucial skill for any business professional. The Discounted Cash Flow (DCF) sensitivity analysis is a powerful tool that helps you understand how changes in key inputs affect the outcome of your financial model.

To perform a DCF sensitivity analysis, you need to identify the key drivers of your company's value. In our example, we identified the terminal growth rate, cost of capital, and discount rate as the main variables that impact the company's present value.

A small change in these variables can have a significant impact on the outcome of your model. For instance, a 1% increase in the terminal growth rate can lead to a 5% increase in the company's present value.

By performing a sensitivity analysis, you can get a better understanding of the risks and opportunities associated with your company's financial projections.

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A financial model is the backbone of any DCF analysis, and it's essential to have a solid setup before performing sensitivity analysis. You must have a financial model or analysis where several key inputs or assumptions directly affect the output, such as the Discount Rate and the Terminal Multiple.

To value any asset or company, you use a formula that takes into account the Discount Rate, Cash Flow, and Cash Flow Growth Rate. The company is worth more when its cash flows and cash flow growth rate are higher, and it's worth less when those are lower.

A company's Discount Rate and Cash Flow Growth Rate change over time, making investment analysis more complex. To represent this change, you divide the company's lifecycle into two periods: the Explicit Forecast Period and the Terminal Period.

The Explicit Forecast Period is where the company's Cash Flow, Cash Flow Growth Rate, and potentially even the Discount Rate change over 5, 10, 15, or 20+ years. The Terminal Period is where the Discount Rate and Cash Flow Growth Rate stop changing because the company is mature.

To perform sensitivity analysis, you can use data tables, which are accessed in the ribbon menu under the Data tab and "What-If Analysis." A properly set-up and formatted sensitivity table looks like this, where you vary the Discount Rate and Terminal Growth Rate to assess the company's implied value.

Here are the two main types of data tables:

In a two-variable data table, you can test up to two variables, such as EBIT margin and revenue growth. However, if you want to test a third variable, you'll need to use a different method, such as goal seek.

The Discount Rate is a critical component of DCF sensitivity analysis, and it's essential to understand how it affects the valuation outcome. It represents the expected, average annualized returns of the company, and in an Unlevered DCF, it's equal to WACC (Weighted Average Cost of Capital).

The Discount Rate is calculated using the WACC formula, which takes into account the Cost of Equity, Cost of Debt, and Cost of Preferred Stock. For example, if a company's dividends are 3% of its current share price, and its stock price has increased by 6-8% each year historically, its Cost of Equity might be between 9% and 11%.

A shortcut method for estimating the Discount Rate involves using the formula: Cost of Equity = Risk-Free Rate + Equity Risk Premium * Levered Beta. This method uses easy-to-find data on 10-year U.S. Treasury yields and the Equity Risk Premium from reputable sources.

The Discount Rate affects the valuation outcome, with a higher rate indicating more risk but also higher potential returns. For instance, if a company's Discount Rate is 5%, it's worth less than if it were 4%. Sensitivity analysis helps to explore the impact of varying assumptions on valuation outcomes, including the Discount Rate.

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To perform sensitivity analysis, you need to identify key inputs or assumptions that affect the valuation outcome. In the case of Walmart, assumptions such as the Discount Rate and the Terminal Multiple directly affect the company's implied share price.

Here are some key inputs to consider when performing sensitivity analysis:

By varying these inputs and observing the changes in valuation outcomes, you can gain insights into the range of potential valuation results and make more informed decisions.

To access sensitivity analysis in Excel, you can find it in the ribbon menu under the Data tab and "What-If Analysis." The shortcut is Alt, D, T or Alt, A, W, T, but note that Mac Excel doesn't have a shortcut.

In Excel, sensitivity analyses are set up as "data tables", which require a specific format. A properly set-up and formatted sensitivity table looks like a table where you vary input variables, such as the Discount Rate and Terminal Growth Rate, to assess a company's implied value.

To create a sensitivity table, you need to follow some key requirements. You must set up the input variables and output on the same spreadsheet as the table, and the numbers in the input row and column cannot be linked to or from anything in the model.

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Microsoft Excel is a powerful tool for data analysis and spreadsheet building. It's widely used and available, making it a great choice for many users.

Excel has a range of functions that make it easy to work with data, including sensitivity analysis. Sensitivity analysis is a way to see how changes in inputs affect outcomes.

In Excel, sensitivity analysis is a type of "What-if" analysis. It helps you understand the impact of different data inputs on your results.

The most common tool for doing sensitivity analysis is Microsoft Excel itself. It's a versatile and widely-used program that's perfect for this type of analysis.

Excel's sensitivity analysis function is a great way to explore different scenarios and see how they affect your data.

To build a sensitivity table in Excel, you need to access it in the ribbon menu under the Data tab and "What-If Analysis". The shortcut is Alt, D, T or Alt, A, W, T, but only available in PC/Windows Excel.

A properly set-up sensitivity table looks like a table with input variables and output on the same spreadsheet, where the numbers in the input row and column are hard-coded numbers or simple percentages.

To set up a sensitivity table, you must have a financial model or other analysis where several key inputs or assumptions directly affect the output. This is because sensitivity analyses won't work if the inputs don't affect the output.

You must also set "Workbook Calculation" in Options or Preferences to "Automatic except for data tables" to avoid slowing down your spreadsheet.

To create a sensitivity table, enter a direct link to the output you want to sensitize in the top-left-hand corner of the table, and then select everything and go through the steps to set up the table.

You cannot modify individual cells in the table once it has been created, so if you want to change something or select different inputs or outputs, you must delete and re-enter the entire table.

Using "Goal Seek" is an excellent function for sensitivity analysis in Excel, especially when you're unsure of a value, like the market risk premium.

Selecting the entire range is a crucial step in creating a sensitivity table in Excel. Select the entire range, including the input cells and output cells, to ensure that the table is updated correctly.

To force a spreadsheet update and see the results, press F9 if the table does not refresh right away. This is especially important when working with complex spreadsheets and multiple tables.

Make sure to enter the row and column input cells in the "Data Table" dialog box to link the inputs to the output. In Example 2, the Terminal Growth Rate and Discount Rate are entered as row and column input cells.

Remember to start each input row or column with a hard-coded number, as linked numbers cannot be used in the model. This is a key requirement for setting up a sensitivity table in Excel, as mentioned in Example 3.

Predicting future growth rates can be tricky, but it's not about getting exact numbers, rather ranges and scenarios that reflect uncertainty.

A DCF model can be sensitive to small changes in assumptions, but this can be a good thing, as it forces you to think critically about your inputs and assumptions.

If the FCF growth rate in the final year of the forecast period is far from the Terminal FCF Growth Rate, it's time to re-examine your assumptions.

The Discount Rate is always based on current market conditions, so the DCF model is not entirely ignoring market conditions.

Some stocks may defy logic and cash flow-based analysis, but they represent a tiny fraction of all public companies worldwide.

A DCF only works for assets that generate cash flow, so it's not suitable for valuing assets like gold or crypto.

Assumption interdependencies are a real issue, as changes in one variable can trigger ripple effects across other parameters.

Data accuracy is crucial, as sensitivity analysis outcomes rely on the accuracy of inputs and data.

Here are some common issues to watch out for when performing DCF sensitivity analysis:

Sensitivity analysis is a game-changer for investors and financial planners, helping them navigate uncertainties and make more informed decisions.

By exploring different scenarios and assessing risks associated with key inputs, stakeholders gain insights into the range of potential valuation results.

This is especially valuable in DCF valuation, where small changes in assumptions can have a significant impact on outcomes.

Employing sensitivity analysis aids in risk mitigation, which is crucial for making robust investment strategies and financial planning.

It's not just about avoiding potential pitfalls, but also about seizing opportunities that may arise from varying market conditions.

By providing a clearer understanding of the dynamics influencing DCF valuations, sensitivity analysis empowers stakeholders to make more confident decisions.

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