1. Base-case scenario
The base case scenario is the one in which the company is expected to perform, or the one with the highest probability of occurring. This is essentially how a company would perform under normal market conditions. Projecting this scenario is important because it serves as the starting point or reference for the level of risk an investor may face and the return they can expect.
The scenario analysis should ideally include separate projections of the company’s price and value. As a reference, investors can use the analyst average or consensus targets for the share price. The value of the company is rather subjective and this is where the need for complex financial models for projections can be replaced by something simpler, intuitive and specific to the business. Generally, projecting the company’s value should include items such as revenue, income and cash flow. Again, investors can refer to analyst targets or estimates, or, if available, even management’s guidance to project the base-case scenario.
2. Worst-case scenario
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The extent to which the worst-case scenario is projected should determine the maximum risk an investor can accept. This represents how much worse a company is expected to perform under the poorest of market conditions. Although the absolute worst-case scenario is that the company goes bankrupt, a financial safety analysis can be conducted to assess the risk.
From the base-case scenario, investors can use the stock’s beta, which measures how volatile the company’s share price is relative to the market. Ideally, this should be done over a longer period and include periods of poor market conditions, such as an industry slowdown or a market crash, to determine the stock’s potential drawdown. The drawdown is the decline from a stock’s highest price to its lowest price over a given period. The same value metrics should be used across all three scenario projections, and investors can refer to extreme worst-case figures from analyst estimates or compare a company’s worst financial years to project the worst-case scenario.
3. Best-case scenario
See also: Understanding price and value in the context of investing, Part 2
The best-case scenario is when the company outperforms expectations significantly or enjoys windfall profits. Projecting this scenario helps the investor understand when the company’s value no longer justifies its share price. In other words, the upper limit of an investor’s return until risk becomes material or significant to the investor.
The company’s best-case scenario share price is technically unlimited, but, as with the worst-case scenario, the stock beta can be used as a reference to determine the point beyond which share price gains are not justified. For a company’s value projections, referring to optimistic analyst estimates or the company’s best financial performance periods can help investors determine the best-case value.
4. Putting it together
After determining the base-case, best-case and worst-case projections for a company, investors should assign a probability to each scenario. The investor can also determine scenarios between the best and worst cases. This probability is subjective, but the base case scenario should have the highest probability. These scenarios include projections of the stock’s value and price.
For example, let’s take Stock A over the next 12 months. Assume the base case is $10 for price and $15 for value, $20 for price and $25 for value for best-case, and $5 for price and $2 for value in the worst-case; and the probability of base case, worst-case and best-case is 60%, 30% and 10% respectively. The probability-adjusted value projection of the stock is (60% x $10) + (30% x $5) + (10% x $20), which sums up to $9.50. The probability-adjusted value projection of the stock is (60% x $15) + (30% x $2) + (10% x $25), which sums up to $12.10.
Since the expected price of $9.50 is lower than the expected value of $12.10, the company is undervalued. It may be subject to further quantitative and qualitative scrutiny and examination by the investor.
5. Example: Singapore Telecommunications (Singtel)
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Investors are free to use any figures or financial metrics they believe are important in determining the company’s value. Still, for this Singtel example, selected figures are used to illustrate how to perform a scenario analysis, and the process is simplified. Investors should note that other analytical methods should be used alongside scenario analysis to fully value a company, such as discounted cash flow and margin of safety analyses. Also, the scenario analysis should not be mistaken for sensitivity analysis, which will be discussed in a future article.
Firstly, the company’s value. To be conservative, let’s use the latest financial year’s figures. Chart 1 shows Singtel’s revenue, net income, operating cash flow (OCF) and free cash flow (FCF) over 20 years from 2006 to 2025. Table 1 shows the annual year-on-year change for these metrics over the same period. The base case would be the average growth rate over this period. For the base case, the figures are 0.7%, 10.9%, 0.5% and –0.5% for revenue, net income, OCF and FCF, respectively. For the worst case, the figures are –7.3%, –79.4%, –20.7% and –25.4%, respectively, while for the best case, they are 13.0%, 250.1%, 18.5% and 25.1%, respectively.
Next, we can use the number of subscribers as a specific operating metric that reflects the company’s value. Chart 2 shows Singtel’s subscriber count from 2008 to 2025. Table 2 shows the annual year-on-year change for this metric over the same period. For the base case, the figures are 1.9%, 4.7%, –0.1% and 3.9%, respectively, for Singtel Mobile Prepaid, Singtel Mobile Postpaid, Optus Mobile Prepaid and Optus Mobile Postpaid. For the worst case, the figures are –14.7%, –0.5%, –12.2% and –14.8%, respectively, while for the best case, they are 23.2%, 9.6%, 10.0% and 16.6%, respectively.
Following this, each value metric can be weighted based on the investor’s discretion. Table 3 shows the weighted value change for Singtel’s base case, worst-case and best-case scenarios, which are 2.4%, –26.6% and 53.1%, respectively.
The goal is to identify key factors expected to influence the company’s value; hence, not all metrics are necessary.
For the period from 20 years ago to the current price of $4.75 for Singtel, the average price was $3.23, the lowest was $2.00 and the highest was $5.21. Hence, the base-case price change would be ($3.23–$4.75)/$4.75, which is –32.0%. The worst- and best-case scenarios are –57.9% and 9.7%, respectively, using this calculation method.
The probability of each case happening can now be assigned. With a 70% probability in the base case and 15% each in the worst- and best-case scenarios, the final price and value changes can be determined. The probability-adjusted value change of the stock is (75% x 2.4%) + (15% x –26.6%) + (15% x 53.1%), which sums up to 5.8%. The probability-adjusted price change of the stock is (75% x –32.0%) + (15% x –57.9%) + (15% x 9.7%), which equals –31.2%.
So, what this implies is that if investors were to buy the stock right now, after accounting for all scenarios, the share price should drop by 31.2%. At the same time, the value should increase by 5.8%. The conclusion is that for every $1 risk (reflected by price) investors take, they can only expect (5.8%/31.2%) or only 0.19 returns (reflected by value).
Hence, based solely on the scenario analysis, investors should hold, sell, or delay buying the stock. However, given the analyst consensus price of $5.30, investors should consider alternative valuation methods for a more thorough analysis.
Disclaimer: This article is strictly for information purposes only and does not constitute a recommendation, solicitation or expression of views to influence readers to buy or sell stocks, including the stocks mentioned. This article does not consider the investor’s financial situation, investment objectives, investment horizon, risk profile, risk tolerance and preferences. Any personal investments should be made at the investor’s own discretion and, after consulting licensed investment professionals, at their own risk. The author of this article does not hold or own any stock(s) featured in this article or have a vested interest in it at the time of writing.
