# What Is Sensitivity Analysis?

## What Is Sensitivity Analysis?

Sensitivity analysis shows how different values of an independent variable affect a dependent variable under a given set of assumptions. Companies use sensitivity analysis to identify opportunities, mitigate risk, and communicate decisions to upper management.

Sensitivity analysis is deployed in business and [economics](https://www.investopedia.com/terms/e/economics.asp) by financial analysts and economists and is also known as a "what-if" analysis.

### Key Takeaways

*   Sensitivity analysis is used to predict how changes in various variables are likely to affect an outcome.
*   It is also called a "what-if" or simulation analysis.
*   Sensitivity analysis is used to predict price changes in stocks and how interest rate changes affect bond prices.
*   Companies use it to inform major decisions based on a range of possible outcomes.

![Sensitivity Analysis](https://www.investopedia.com/thmb/ywR4-arXTDp2o5mK9Lpf59sJxQQ=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Sensitivity-Analysis-v1-003f8e24c62547bab3d1bd239f21c2b8.png)

*— Investopedia / Lara Antal*

## How Sensitivity Analysis Works

Sensitivity analysis is a financial model that determines how target variables are affected based on changes in input variables. By creating a given set of variables, an analyst can determine how changes in one variable affect the outcome.

Sensitivity analysis enables forecasting based on historical, true data. By studying all the variables and the possible outcomes, decisions can be made about business activities and investing decisions,

Sensitivity analysis can be used to:

*   Make predictions about the share prices of [public companies](https://www.investopedia.com/terms/p/publiccompany.asp). Some variables that affect stock prices include company earnings, the number of shares outstanding, the [debt-to-equity ratios](https://www.investopedia.com/terms/d/debtequityratio.asp) (D/E), and the number of competitors in the industry.
*   Determine the effect that changes in interest rates have on bond prices. In this case, the interest rates are the independent variable, while bond prices are the dependent variable.

## How Businesses Use Sensitivity Analysis

Sensitivity analysis can provide management feedback useful in many different scenarios including:

*   **Understand influencing factors.** What external factors can affect the outcome of a specific project or undertaking, and how they affect it. This allows management to see what input variables may impact output variables.
*   **Reduce uncertainty.** Complex sensitivity analysis models inform project members what to be alert for or what to plan for.
*   **Catch errors.** The original assumptions for the baseline analysis may have had some uncaught errors. By performing analytical iterations, management can catch mistakes in the original analysis.
*   **Simplify the model.** The analysis reveals what factors don't matter and can be removed from the model.
*   **Communicate results.** Upper management may already be defensive. Compiling analysis on different situations helps inform decision-makers of other possible outcomes.
*   **Achieve goals.** Management sets specific benchmarks for long-term [strategic plans](https://www.investopedia.com/financial-edge/0612/the-importance-of-strategic-planning.aspx). By performing sensitivity analysis, a company can better understand how a project may change and what conditions must be present for the team to meet its targets.  
    

> **Fast Fact**
>
> Because sensitivity analysis answers questions such as "What if XYZ happens?", this type of analysis is also called what-if analysis.

## Example

A sales manager wants to understand the impact of customer traffic on total sales. The company determines that sales are a function of price and transaction volume. The price of a widget is $1,000, and the company sold 100 last year for a total sales of $100,000.

The manager determines that a 10% increase in customer traffic increases transaction volume by 5%. This allows the company to build a [financial model](https://www.investopedia.com/terms/f/financialmodeling.asp) and sensitivity analysis based on what-if statements. It can tell the manager what happens to sales if customer traffic increases by 10%, 50%, or 100%.

Based on 100 transactions, a 10%, 50%, or 100% increase in customer traffic equates to an increase in transactions by 5%, 25%, or 50% respectively. The sensitivity analysis demonstrates that sales are sensitive to changes in customer traffic.  

## Advantages and Disadvantages

Sensitivity analysis provides several benefits for managers considering major decisions. It acts as an in-depth study that reveals potential hazards as well as the potential rewards to an undertaking. It allows decision-makers to identify where they can make improvements in the future to avoid some adverse outcomes.

However, the outcomes can only be estimates, not hard facts. Forecasting is by definition based on historical data.

Models with too many variables may distort a user's ability to evaluate influential variables.

Pros

*   May help management target specific inputs to achieve more specific results
    
*   May communicate areas to focus on or risks to control
    
*   May identify mistakes in the original benchmark
    
*   May reduce the uncertainty and unpredictability of an undertaking
    

Cons

*   Relies on historical data, not hard facts
    
*   May become overly complicated which distorts analysis
    
*   Results may be inaccurate due to flaws in the integration of many independent variables
    

## What Is Sensitivity Analysis in NPV?

Sensitivity analysis in net present value, or NPV, measures the changes in the potential profitability of a project based on changes to underlying input variables. Though a company will have calculated its [net present value](https://www.investopedia.com/terms/n/npv.asp), it may also want to understand how better or worse conditions will impact the numbers. 

## How Do Businesses Calculate Sensitivity Analysis?

Sensitivity analysis is undertaken in specialized analysis software. [Microsoft Excel](https://www.investopedia.com/ask/answers/021115/what-formula-calculating-net-present-value-npv-excel.asp) has functions to perform the analysis.

In general, sensitivity analysis is calculated using formulas with different input cells. For example, a company may perform NPV analysis using a discount rate of 6%. Sensitivity analysis can be performed by analyzing scenarios of 5%, 8%, and 10% discount rates and maintaining the formula but referencing the values of each variable.

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

A sensitivity analysis is not the same as a [scenario analysis](https://www.investopedia.com/terms/s/scenario_analysis.asp). Assume an equity analyst wants to do a sensitivity analysis and a scenario analysis around the impact of [earnings per share](https://www.investopedia.com/terms/e/eps.asp) (EPS) on a company's relative valuation by using the price-to-earnings (P/E) multiple.

The sensitivity analysis is based on the variables that affect valuation, which a financial model can depict using the variables' price and EPS.

For a scenario analysis, an analyst determines a certain scenario such as a [stock market crash](https://www.investopedia.com/terms/s/stock-market-crash.asp) or change in industry regulation that would affect the company's valuation.

## The Bottom Line

When a company wants to understand the range of potential outcomes for a given project, it may perform a sensitivity analysis. Sensitivity analysis entails manipulating independent variables to determine the resulting financial impacts. Companies employ it to identify opportunities, mitigate risk, and communicate decisions to upper management.