12.4The Competitive Analysis Approach

We previously discussed how financial analysis tools can be used to clarify the think-

ing of a corporation’s long-run strategic planners. This section turns the tables some-

what by discussing how issues typically considered by strategic planners can be used

to analyze the value created by specific projects.

Determining a Division’s Contribution to Firm Value

In many cases, it is impossible to unravel the contribution of a particular division to

a firm’s value. For example, trying to obtain the appropriate price/earnings ratio for

an investment in toothpaste production by examining the financial statements of mul-

tiproduct companies like Procter & Gamble or American Home Products is pointless:

Their toothpaste divisions account for only a small part of the performance reported

in their consolidated financial statements. However, with a great deal of confidence,

one can assert that toothpaste is a product that will continue to be used in the future.

In addition, it is likely that a firm probably has a positive net present value project

if it either can produce toothpaste more cheaply or sell it more effectively than its

competitors. If this is not the case, the project’s net present value is probably nega-

tive. In other words, the NPVof a project is ultimately determined by a firm’s advan-

tages relative to those of its competition. Afirm that can accurately assess its com-

petitive advantages may find that this is the best method of assessing the NPVof a

project.

Result 12.8

(The Competitive Analysis Approach.)Firms in a competitive market should realize that theycan only achieve a positive NPVfrom a project if they have some advantage over theircompetitors. When other firms have competitive advantages, the project has a negative NPV.

Disadvantages of the Competitive Analysis Approach

The competitive analysis approach, like the other valuation methods, has its pitfalls.

In the early 1980s, for example, most oil firms were spending more to explore for

oil than the oil was worth. Because the competitive analysis approach implicitly

assumes value-maximizing competitors, it could lead a value-maximizing firm astray

when this assumption is false. Amanager of a firm with non-value-maximizing com-

petitors might accurately project the demand for oil in the foreseeable future and

correctly ascertain that it has a competitive advantage in its production (for exam-

ple, lower costs). The manager might assume that, even if oil prices declined, less

efficient competitors would stop production before the price level dropped to a point

where the firm starts to incur losses. Given these assumptions, the competitive analy-

sis approach suggests that oil exploration is a good investment. However, if other

firms are in the oil business for reasons other than value-maximization (for instance,

company pride), the manager may find that as oil prices decline competitors do not

¹³See

Exercise 12.11 for an algebraic solution to this problem.

Grinblatt918Titman: Financial	III. Valuing Real Assets	12. Allocating Capital and	© The McGraw918Hill
Markets and Corporate		Corporate Strategy	Companies, 2002
Strategy, Second Edition

452Part IIIValuing Real Assets

exit or, possibly, even increase production, believing they can survive a “price war”

and drive prices even lower. This type of market would be unattractive, even for the

lowest-cost firm.¹⁴