# Sensitivity Analysis – How It’s Used in Banking, Private Equity, Trading, Investing

## What Is Sensitivity Analysis?

Sensitivity analysis is the process of changing input variables to determine how it will change the output variable.

For example, if you are doing a discounted cash flow analysis on a certain stock, you might want to look at how changing interest rates would influence the stock price or how changing revenue or costs would impact the estimated reading.

Sensitivity analysis is a key tool in financial analysis because it allows you to see how changes in underlying assumptions can impact your results.

## Types of Sensitivity Analysis

There are two types of sensitivity analyses: univariate and multivariate.

Univariate sensitivity analysis looks at how changing one variable will impact the result, while multivariate sensitivity analysis looks at how changing multiple variables will impact the result.

### Univariate Sensitivity Analysis

The most common type of sensitivity analysis is univariate sensitivity analysis. This type of sensitivity analysis looks at how changing one variable impacts the result.

For example, if you are doing a discounted cash flow analysis on a certain company, you might want to look at how an increase in operating expenses of a certain amount would flow into the share price.

### Multivariate Sensitivity Analysis

Multivariate sensitivity analysis looks at how changing multiple variables impacts the result.

For example, if you are doing a discounted cash flow analysis on a certain stock, you might want to look at how changing interest rates, revenue, and costs would all impact the estimated value of the stock.

This type of analysis is more complicated than univariate sensitivity analysis, but it can give you a better understanding of how the different variables interact with each other.

## Why Is Sensitivity Analysis Important?

Sensitivity analysis is important because it allows you to see how your results change when you change the underlying assumptions.

This is important because it allows you to understand the risks and opportunities associated with a certain investment.

For example, if you are doing a discounted cash flow analysis on a stock, and you find that the stock price is very sensitive to changes in interest rates – i.e., likely because more of its cash flows are discounted far out in the future – then you know that rising interest rates could have a big impact on the stock price.

Sensitivity analysis is used in all forms of finance – corporate finance, investment banking, private equity, and public market investing.

The following video looks at sensitivity analysis as it pertains to a leveraged buyout (LBO) analysis in private equity.

## How to Do Sensitivity Analysis

There are two main ways to do sensitivity analysis: holding all other variables constant and changing one variable at a time, or using a Monte Carlo simulation.

### Holding All Other Variables Constant

The most common way to do sensitivity analysis is to hold all other variables constant and change one variable at a time.

For example, if you are doing a discounted cash flow analysis on a stock, you might want to hold the interest rate constant and see how changes in the revenue impact the estimated value of the stock.

If you change a bunch of variables at once on your spreadsheet, then you won’t know the relative influence of each.

Therefore, it is best to change one variable at a time and see how it impacts the result.

### Monte Carlo Simulation

Another way to do sensitivity analysis is through Monte Carlo simulation.

This approach randomly generates values for all of the variables and then simulates how those changes would impact the result.

For example, if you are doing a discounted cash flow analysis on a stock, you might want to use a Monte Carlo simulation to generate different values for interest rates, revenue, and costs and see how those changes impact the estimated value of the stock.

This approach can be helpful because it allows you to see how all of the variables interact with each other.

However, it is important to note that Monte Carlo simulations are only as good as the assumptions that you put into them.

Therefore, you need to be careful not to over-rely on Monte Carlo simulations.

## How Can I Apply Sensitivity Analysis to My Investment Decisions?

Sensitivity analysis can be helpful to determine what you’d ultimately be willing to pay for an asset or security.

You can look at a company’s current financial information and then change it on your spreadsheet.

For example, what if revenue is cut by 20 percent?

What if expenses go up by 20 percent?

What if interest rates rise by 500bps?

You can then use all that to envision worst-case scenarios to see how bad things could theoretically get.

Then you can use that price as a type of baseline for when to buy. You could even sell a cash-covered put at that strike level and get paid to wait.

In a nutshell, sensitivity analysis is used to see how your results change when you change the underlying assumptions. This is important because it allows you to understand the risks and opportunities associated with a certain investment.

## Scenario Analysis

Scenario analysis is the process of estimating the expected value of a portfolio after a given change in the values of key factors take place.

It is a type of sensitivity analysis that is used to analyze how different outcomes could affect the value of a portfolio.

Scenario analysis can be helpful in investment decision-making because it allows you to see how your portfolio would be affected by different changes in the market.

For example, if you are considering investing in a stock, you might want to do a scenario analysis to see how the stock would be affected by a change in corporate strategy or new competitors.

You can then use this information to make a more informed investment decision.

Scenario analysis is often more qualitative than sensitivity analysis.

## What is the Difference Between Sensitivity Analysis and Scenario Analysis?

The main difference between sensitivity analysis and scenario analysis is that sensitivity analysis looks at how one variable changes while holding all other variables constant, while scenario analysis looks at how a combination of variables could change.

Sensitivity analysis is typically used to identify which variables have the biggest impact on the result.

Scenario analysis is typically used to estimate the expected value of a portfolio after a given change in the values of key factors take place.

Both sensitivity analysis and scenario analysis can be helpful in investment decision-making.

Which one you use will depend on your specific goals and needs.

## What Is Cost-Benefit Analysis, How Is it Used, What Are its Pros and Cons?

Cost-benefit analysis is a tool that is used to help make investment decisions.

It is a type of analysis that looks at the costs and benefits of a potential investment in order to determine whether or not it is worth making.

A cost-benefit analysis typically includes both quantitative and qualitative factors.

The quantitative factors would include things like the expected return on investment, the risk involved, and the initial investment amount.

The qualitative factors would include things like the impact of the investment on the environment or on society.

Cost-benefit analysis can be helpful because it allows you to see all of the potential costs and benefits of an investment before you make it.

### Cost-benefit analysis drawbacks

However, cost-benefit analysis does have some drawbacks.

One of the biggest drawbacks is that it can be difficult to assign a monetary value to some of the factors involved.

This can make it difficult to accurately compare the costs and benefits.

Another drawback is that cost-benefit analysis often does not consider things like opportunity cost if it’s only looking at something in isolation.

Opportunity cost is the potential return you could have earned if you had invested your money in something else.

For example, if you invest \$100 in stock A, you are giving up the opportunity to invest that \$100 in stock B.

The opportunity cost of investing in stock A is the return you could have earned if you had invested in stock B.

When cost-benefit analysis may not consider opportunity cost, it might lead you to make suboptimal investment decisions.

## Risk Analysis

Risk analysis is the process of assessing the likelihood of an adverse event occurring.

It is a type of analysis that is used to help make investment decisions and prevents making bad decisions.

Risk analysis looks at the potential risks and rewards of an investment in order to determine whether or not it is worth making.

A risk-reward analysis typically includes both quantitative and qualitative factors.

The quantitative factors would include things like the expected return on investment, the risk involved, and the initial investment amount.

The qualitative factors would include things like the impact of the investment on the environment or on society.

Risk analysis can be helpful because it allows you to see all of the potential risks and rewards of an investment before you make it.

## FAQs – Sensitivity Analysis

### What is a sensitivity analysis?

A sensitivity analysis is a type of analysis that looks at how one variable changes while holding all other variables constant.

It is often used in investment decision-making because it allows you to see which variables have the biggest impact on the result.

For example, if you are considering investing in a stock, you might want to do a sensitivity analysis to see how the stock would be impacted by an adverse change in interest rates.

You can then use this information to build out a distribution of expectations or at least a better understanding of what can go wrong.

### What is a scenario analysis?

A scenario analysis is a type of sensitivity analysis that looks at how a change in one variable would affect the result under different scenarios.

For example, you might want to do a scenario analysis to see how your investment would be affected if a certain one of its internal initiatives failed, if an M&A transaction fails to go through, or what would happen if a certain law was passed.

### What is a Monte Carlo Simulation?

A Monte Carlo simulation is a type of computerized mathematical technique that can be used to estimate the probability of certain outcomes.

It is often used in investment decision-making because it allows you to see how your investment or portfolio would be affected by different changes in the market.

For example, if you are considering investing in a stock, you might use a Monte Carlo simulation to see how the stock would be affected by a change in interest rates.

You can then use this information to make a more informed investment decision.

## Conclusion – Sensitivity Analysis

Sensitivity analysis is a valuable tool that can help you understand the risks and opportunities associated with an investment.