# Sensitivity Analysis in FCFF and FCFE Valuations

Sales growth and profit margins depend on the growth phase of the firm and the profitability of the industry. Growth rates and duration of growth are difficult to forecast. The base year values of FCFF and FCFE growth models are important as the firm’s value will increase/decrease proportionately with the initial value of FCFF or FCFE.

Analysts perform a sensitivity analysis to determine how sensitive the final value is to changes in each of a valuation model’s inputs. Some inputs have a more significant impact on stock than others, e.g., revenue growth rate.

Some sources of errors in valuation results include:

• Estimating the future growth rate of FCFF and FCFE.
• Choosing the correct base years for the FCFF and FCFE growth forecasts.

## Question

Which of the following is the least likely source of error in valuation results?

1. The duration of growth rate.
2. Estimating the future growth rate of FCFF and FCFE.
3. Choosing the correct base year for the FCFF and FCFE growth forecasts.

#### Solution

The duration of growth rate is not a source of error in valuation. However it is difficult to forecast.

B is incorrect. Estimating the future growth rate of FCFF and FCFE is a source of error in valuation results as a small change in growth rate results in a substantial difference in the computed value.

C is incorrect. Choosing the correct base year for the FCFF and FCFE growth forecasts is a source of error as the firm’s value will increase/decrease proportionately with the initial value of FCFF and FCFE.

Reading 24: Free Cash Flow Valuation

LOS 24 (k) Explain the use of sensitivity analysis in FCFF and FCFE valuations.

Shop CFA® Exam Prep

Offered by AnalystPrep

Featured Shop FRM® Exam Prep Learn with Us

Subscribe to our newsletter and keep up with the latest and greatest tips for success

Daniel Glyn
2021-03-24
I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
michael walshe
2021-03-18
Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.
Nyka Smith
2021-02-18
Every concept is very well explained by Nilay Arun. kudos to you man!