Saturday Brain Storming Thought (175) 10/06/2023
PROBABILITY ANALYSIS
In financial modelling and investment appraisal, Probability Analysis is a technique used by analysts to capture the effects of different future occurences and events on the financial forecast of a business such as accidental and business losses
Probability Analysis
1) calculate the values of possible outcome
2) their probability distribution
3) value of worst possible outcome and it’s probability
4) probability than an investment will generate a positive NPV
5) Standard deviation of possible outcome
6) expected value of NPV
7) lessons the impact and deal with risk
Meaning of Probability
Probability is the likelihood of an event or more than one event occuring
Probability represents the possibility of acquiring a certain outcome and can be calculated using a simple formula
Probability Formula
Probability = (Number of favorable outcomes) / (total number of outcomes)
P(A) = f / N
P(A) = probability of (event A) occuring
f = number of ways an event can occur (frequency)
N = total number of outcomes possible
Types of Probability
1) Classical Probability – it describes an event where there are equal odds
2) Empirical Probability – it is based on historical data and uses data from a sample data set to determine the probability of an outcome occuring again
3) Subjective Probability – it takes into account no calculations, based on own experience
4) Axiomatic Probability – it involves certain rules or axioms
a) probability of an event is greater or equal to zero
b) probability that at least one of the outcomes will occur at 1
c) events A and B are mutually exclusive
General Probability Rules
1) probability of an impossible event is zero
2) sum of all the probabilities for all possible events is equal to one
3) P (A c) = 1 – P(A)
4) probability that either one or both events occur
5) probability of both events occur
6) conditional probability
Range of Probability
0 <= P (A) <= 1
It is not possible to have s probability less than zero or greater than one
The probability of the outcome of an experiment is never negative
Limitations of Probability
1) it can not handle events with an infinite number of possible outcomes
2) it akso can not handle events where each outcome is not equally – likely
Objective Probability
It is the likelihood of occurrence of an event that is based on historical data
Probability used in management
Probability helps ch companies estimate expected returns from an investment decision based on
Market response
Consumption trends
Market prices
Consumer feedback
Other external forces
Probabilistic approaches in valuation
In probabilistic approaches, we deal with uncertainty more explicitly by
1) Sensitivity Analysis – asking what if questions about key inputs and looking at the impact on value
2) Scenario Analysis – looking at the cash flows/ value under different scenarios for the future
3) Simulations analysis – using probability distributions for key inputs, rather than expected values, and computing value as a distribution as well
Fine Tuning what if analysis
1) don’t double count risk
2) less is more
3) a picture is worth a thousand numbers
Compiled by
Compiled by:
Er. Avinash Kulkarni
9822011051
Chartered Engineer, Govt Regd Valuer, IBBI Regd Valuer