A scenario analysis is the outcome of the average of the various forward looking scenarios, the probability of the scenario, scenario earnings, P/E multiple etc. With the experience of trading over the years, the investor develops the ability to go against the grain, arrive at correct projections, to decide the prospects for a given company. As you work through various company balance sheets, your skill is refined, and you are confident about arriving at correct judgments.
One needs to know emphatically that more than one factor affects the share price at a given time. Scenario analysis is all about the factors that influence the market trends. The stock prices can not be judged accurately in terms of a single outcome. Think of the ever growing and ever spreading octopus, when you think of the movement in the share market. It functions as per its will and its agendas of movements are only known to it. Let me hasten to add that it does not function in a callous manner. Only its style of functioning is not within the easy grasp of the investors. So, an investor can not come up with one way of thinking about the future of the company, howsoever strong may be its foundation and the managing team. Stay away from this type of valuation model and think about the multiple outcomes for a company's share.
One of the following two types of scenarios rules the market--Negative scenario and Positive scenario. Having done this broad classification, let us move to the specifics and try to create a set of three scenarios. This type of classification assumes importance in these worst years of depression that has engulfed the market, and most of the forecasts by the experts have gone haywire! In the light of this development, we are now discussing three scenarios-a worst-case scenario, a base case scenario and a best-case scenario. Those who have some understanding, as to the ways of the functioning of the share market, further explanation is not necessary about the import of these terms. The first one relates to the present state of affairs. The investors are grappling with the second type of scenario, trying desperately to find out the base. The third type of scenario existed during the Bull Run, which preceded the depression trends. This analysis applies to the share of the given company.
Scenario analysis will help you to sharpen your analytical skills and arrive at investment decisions with better focus. You will think about a particular share without fear or favor. Even when your final analysis shows the best results about a company, you calculate from the negative perspective and see whether the scale weights evenly or tilts towards the negative side. In your first flush of enthusiasm to go for a particular share, you might have overlooked certain hidden factors. In scenario analysis, try to be your own friend, and your own enemy as for judging the merits of a particular share. Such impartial approach will strengthen your power of judgment.
Insights acquired from scenario analysis should then be compared to the scenarios in market expectations. Such comparisons are necessary for making an honest assessment to locate the possible differences.
In scenario analysis, some types of numerical ways to determine share valuation come to the fore. Each type has its merits but the overall decision has to be taken by the investor, taking into consideration the market conditions prevailing at a given time. Such valuation types are, discounted cash flow, ratio analysis, yield analysis, expected value etc.
Scenario analysis and stress testing are identical. You are basically examining various economic situations and sieve the results. Stress testing is trying to understand the vulnerability of a portfolio, taking into consideration changing key variables. That can be in terms of a specific scenario or a group of historical and current events that are likely to have the bearing on the price of a share.