DCF DCF Sensitivity Analysis 2 — Questions and Answers
Question 1: A company's DCF valuation drops by 15% when WACC rises from 9% to 10%. What does this tell the analyst?
- The model is highly sensitive to the discount rate (Correct answer)
- The terminal growth rate is too high
- Free cash flows are declining
- The company has excess debt
Correct answer: The model is highly sensitive to the discount rate
A 15% valuation drop from a 1% WACC increase shows the model is highly sensitive to the discount rate, warranting careful WACC estimation.
Question 2: What is a 'scenario analysis' in DCF modeling, and how does it differ from sensitivity analysis?
- Scenario analysis changes multiple assumptions simultaneously; sensitivity analysis changes one at a time (Correct answer)
- Scenario analysis uses Monte Carlo simulation; sensitivity analysis uses data tables
- Scenario analysis only tests upside cases; sensitivity analysis tests downside
- They are identical in practice
Correct answer: Scenario analysis changes multiple assumptions simultaneously; sensitivity analysis changes one at a time
Scenario analysis (bull/base/bear) adjusts multiple variables at once to reflect coherent economic conditions, while sensitivity analysis isolates individual inputs.
Question 3: In DCF sensitivity analysis, why is the terminal growth rate particularly important to stress-test?
- Terminal value often represents 60–80% of total DCF value (Correct answer)
- Terminal growth rate is always set to zero in practice
- It directly equals the company's dividend growth rate
- It has no impact on the discount factor
Correct answer: Terminal value often represents 60–80% of total DCF value
Because terminal value typically dominates total DCF value, small changes in the terminal growth rate can dramatically shift the overall valuation.
Question 4: An analyst runs a sensitivity analysis and finds the DCF value is relatively stable across a wide range of WACC inputs. What might explain this?
- The terminal value is a small portion of total value due to high near-term cash flows (Correct answer)
- The WACC was incorrectly calculated
- The free cash flows are too low
- The tax rate assumption is too conservative
Correct answer: The terminal value is a small portion of total value due to high near-term cash flows
When near-term cash flows dominate total value, varying the discount rate has less impact because near-term flows are discounted fewer periods.
Question 5: Which sensitivity analysis approach assigns probabilities to different scenarios to calculate an expected DCF value?
- Monte Carlo simulation (Correct answer)
- Data table analysis
- Tornado chart
- Goal seek
Correct answer: Monte Carlo simulation
Monte Carlo simulation runs thousands of random draws from probability distributions for each input to produce an expected value and confidence intervals.
Question 6: When presenting DCF results to management, why is it best practice to show a sensitivity table rather than a single point estimate?
- It communicates the range of outcomes given assumption uncertainty (Correct answer)
- It eliminates the need for WACC calculation
- It proves the stock is undervalued
- It replaces the need for comparable company analysis
Correct answer: It communicates the range of outcomes given assumption uncertainty
A single point estimate implies false precision; a sensitivity table honestly communicates how valuation varies with the uncertainty inherent in key assumptions.
DCF DCF Sensitivity Analysis 2
A company's DCF valuation drops by 15% when WACC rises from 9% to 10%.
What does this tell the analyst?