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For What It’s Worth: Sensitivity Analysis – October 2015

Sensitivity analysis is a way of determining the importance of various valuation assumptions. It asks the question: if something changes, how much does the value conclusion change? If it changes a lot, the assumption is “sensitive” and could be argued. If it does not, the assumption is “insensitive” in that it does not make much difference in the end.

We are appraising a business that earns revenues of $100 and EBITDA of $1. We decided that the most appropriate valuation method is to capitalize next year’s earnings at a multiple of 4. In this simple example, the only moving parts are the forecast of next year’s revenue and profit margin. We think that the most probable forecast is sales of $105 and EBITDA of $1.05, based on a 5% growth rate for sales and a constant 1% profit margin. At a multiple of 4, the equity is worth $4.20.

Now let’s do a sensitivity analysis:

  1. What if sales grow twice as fast? Then they will increase 10% to $110. With a constant profit margin, EBITDA will be $1.10 and the equity value will be $4.40. We doubled the sales growth rate (to 10% from 5%) but the value went up only $0.20 or less than 5%. The value is thus not very sensitive to the sales growth rate. If sales fall or rise a little bit, our value conclusion will be almost the same. As long as “fall or rise a little bit” is a plausible forecast, this assumption is not important because the value is not sensitive to it.
  2. What if profit margin doubles? Then sales will be $105, EBITDA will be $2.10, and the equity value will be $8.40. Profit margin doubles, and equity value goes up over 90%. The value conclusion is thus very sensitive to the profit margin assumption, and we need to take great care to establish why we think that the profit margin will be constant. Small increases or decreases in margin will have a big value impact: this is a very sensitive assumption.

That is the story of sensitivity analysis: see how much the value changes relative to changes in key assumptions, determine which ones are the most important, and be able to defend the basis for them.

Valuations play a part in all tax, transaction, and litigation matters. For additional information or advice on a current one, please do not hesitate to call.

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About Western Reserve Valuation Services LLC
Western Reserve Valuation Services LLC, based in Columbus, Ohio, is a leading provider of valuation services and financial opinions relating to corporate finance transactions, corporate tax planning and compliance, succession planning and wealth preservation, employee stock ownership plans (“ESOPs”), financial reporting and portfolio / fund valuations. For more information, visit www.wesresvaluation.com or call (614) 448-3700.

Western Reserve Valuation Services is an affiliate of Western Reserve Partners LLC, a FINRA-member investment banking firm offering financial advisory services relating to mergers and acquisitions, capital raising and financial restructuring. For more information on Western Reserve Partners, please www.wesrespartners.com or call (216) 589-0900.

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