Damodaran on probabilistic approaches to risk assessments in finance:
• In the most extreme form of scenario analysis, you look at the value in the best case and worst case scenarios and contrast them with the expected value. In its more general form, you estimate the value under a small number of likely scenarios, ranging from optimistic to pessimistic.
• Decision trees are designed for sequential and discrete risks, where the risk in an investment is considered into phases and the risk in each phase is captured in the possible outcomes and the probabilities that they will occur. A decision tree provides a complete assessment of risk and can be used to determine the optimal courses of action at each phase and an expected value for an asset today.
• Simulations provide the most complete assessments of risk since they are based upon probability distributions for each input (rather than a single expected value or just discrete outcomes). The output from a simulation takes the form of an expected value across simulations and a distribution for the simulated values.
With all three approaches, the keys are to avoid double counting risk (by using a riskadjusted discount rate and considering the variability in estimated value as a risk measure) or making decisions based upon the wrong types of risk.
