Practical stock researchModule 3, lesson 12 of 23
Building scenarios from assumptions
Writing assumptions as testable statements, linking them to business drivers, building bear, base and bull values, and assigning rough probabilities honestly.
In this lesson
- Write valuation assumptions as specific statements that later evidence can confirm or contradict.
- Link each scenario to the business drivers identified in research.
- Build bear, base and bull scenario values and a probability-weighted value.
- Explain why the base case is not necessarily the most likely outcome.
Builds on
- Choosing a valuation methodScenarios are built with the valuation method chosen there.
- Sensitivity and scenario analysisThat lesson introduces sensitivity tables and scenarios.
On this page
In simple terms
Any valuation is a set of guesses about the future turned into a number. Scenarios make those guesses visible: instead of one number that hides its assumptions, you get a range of values, each tied to a story about how the business might develop. That makes it easier to see what you are betting on and what could go wrong.
Write assumptions you can test
Vague assumptions cannot be checked. Specific ones can.
| Vague | Testable |
|---|---|
| "Strong growth" | "Volumes grow 8% a year for five years" |
| "Margins improve" | "Operating margin rises from 14% to 17% by year 3 as the new plant fills" |
| "Market leader" | "Market share stays between 30% and 35%" |
| "Reasonable valuation" | "The market pays 25 times earnings in year 5" |
Testable assumptions let you monitor the thesis later, as the monitoring lesson explains.
Build scenarios from drivers
Use the few drivers that matter most for the business, found in the products and customers research. Each scenario should be a coherent story, not just the base case with every number shifted.
Worked example: Three made-up scenarios for a consumer company
| Driver | Bear | Base | Bull |
|---|---|---|---|
| Volume growth, yearly | 3% | 8% | 12% |
| Operating margin in year 5 | 12% | 16% | 19% |
| Exit P/E in year 5 | 18 | 25 | 30 |
| Story | Competition intensifies; price cuts | Steady share gains; new plant fills | New categories succeed |
| Value per share | ₹300 | ₹550 | ₹900 |
| Rough probability | 30% | 50% | 20% |
| Probability-weighted value: 0.3 × 300 + 0.5 × 550 + 0.2 × 900 | ₹545 |
|---|---|
| Current price | ₹500 |
| Fall to the bear value: (500 − 300) ÷ 500 | 40% |
| Rise to the bull value: (900 − 500) ÷ 500 | 80% |
The weighted value is only slightly above the price, and there is a meaningful chance of a 40% fall. Whether that is attractive depends on the investor's margin of safety and position size.
Probabilities: rough and honest
Assigning probabilities forces you to say how likely you think each story is. But they are judgements, not measurements:
- Round them; 30% is more honest than 27.5%.
- Check them against what has happened to similar companies, not just this one.
- Do not let the bull case get a high probability simply because you like the company.
The weighted value is an expected value, useful for thinking but no more precise than its inputs.
The base case is not the forecast
The base case is a central estimate. Real outcomes often land outside all three scenarios, because of events nobody modelled. Treat scenarios as a way to understand the range of possibilities and what drives them, not as a promise that the truth lies between bear and bull.
Start with the bear case
Many investors build the base case first and treat the bear case as an afterthought. Reverse that:
- What is a realistic bad outcome, and what would the share be worth?
- Could you live with that loss, given your position size, as the position sizing lesson explains?
- Only then ask what the upside might be.
Cross-check with the market
A reverse DCF shows what the current price already assumes. If the price implies something close to your bull case, the market is more optimistic than your base case, and you need a good reason to disagree.
Why it matters
Scenarios turn a single, falsely precise number into an honest picture of uncertainty. They reveal which assumptions matter, how much you could lose, and what to watch, which is the foundation of a written thesis.
Limitations
Scenarios are only as good as the drivers and stories chosen. Probabilities are subjective. Rare events can make every scenario wrong. More scenarios do not mean more accuracy.
Common mistakes
- Vague assumptions that cannot be checked.
- Bear cases that are too mild.
- Precise-looking probabilities.
- Treating the base case as a forecast.
Try it yourself
- For a company you are researching, list the three drivers that matter most.
- Write testable bear, base and bull assumptions for each, and the story behind each scenario.
- Value each scenario and assign rough probabilities.
- Calculate the fall to your bear value and decide whether you could live with it.
Key takeaways
- Write each assumption as a specific, checkable statement, such as "volumes grow 8% a year for five years", not "strong growth".
- Build scenarios from the business drivers that matter most, so each scenario tells a coherent story.
- A probability-weighted value combines scenarios, but the probabilities are rough judgements and should be treated as such.
- The base case is a central estimate, not a forecast of what will happen. Real outcomes often land outside all scenarios.
- Look at the bear case first. If you could not live with it, the price or the position size may be wrong.
Check your understanding
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Terms used in this lesson
- Scenario analysis
- Valuing a business under several complete, internally consistent futures, such as bear, base and bull cases.
- Expected value
- The average result of a decision if it could be repeated many times, found by weighting each outcome by its probability.
- Margin of safety
- The gap between an estimate of a share's value and the price paid, giving room to be wrong without a large loss.
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This lesson is general education, not investment advice. Examples use made-up or clearly dated figures to explain ideas; they are not recommendations. Read the disclaimer.