If scenario analysis and decision trees are techniques that help us assess the effects of discrete risk, simulations provide a way of examining the consequences of continuous risk. To the extent that most risks that we face in the real world can generate hundreds of possible outcomes, a simulation gives us a fuller picture of the risk in an asset or investment.

Steps in Simulation

Unlike scenario analysis, where we look at the values under discrete scenarios, simulations allow for more flexibility in how we deal with uncertainty. In their classic form, distributions of values are estimated for each parameter in the valuation (growth, market share, operating margin, beta). In each simulation, we draw one outcome from each distribution ...

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