12.5When to Use the Different Approaches

Part III of the text has discussed a number of different approaches to real asset valua-

tion. The approaches in Chapters 10 and 11 include discounted cash flow, using the

risk-adjusted discount rate and certainty equivalent approaches, and internal rate of

return. This chapter has discussed the real options, ratio comparison, and competitive

analysis approaches. Which approach or set of approaches should a manager use?

Can These Approaches Be Implemented?

Some of these approaches may be difficult to apply in practice. For instance, the intu-

ition gained from the examples that employ the real options approach in this chapter

is always going to be useful, but this advanced valuation technique is not always applied

easily. For example, the strategic options associated with many investment projects are

difficult to specify before the project is actually initiated. Moreover, it frequently is

impossible to estimate the random process (for example, the binomial tree) that gener-

ates the future asset prices that determine the investment’s present value. This makes

it difficult to apply the real options approach literally. It is also difficult in many cases

to estimate the expected or certainty equivalent cash flows of an investment, so the dis-

counted cash flow method also may be difficult to implement reliably.

Valuing Asset Classes versus Specific Assets

In addition, when asking questions like “Is real estate a good investment?,” the real

options and the ratio comparison approaches cannot be used. These approaches are

based on a comparison between highly similar investments and reveal little about the

relative pricing of widely disparate classes of assets, so they are not effective for iden-

tifying whether broad asset classes are mispriced.

To determine the attractiveness of real estate investments as a group, one would

have to determine the risk of a broad-based portfolio of real estate investments and

assess whether the financial markets are appropriately pricing that risk. Therefore, it is

best for this purpose to use a model—either the CAPM or the APT—that makes state-

ments about the risk-return relation across asset classes. In contrast, given the empiri-

cal shortcomings of the CAPM and APT(see Chapters 5 and 6), one should look to

alternatives in more specific cases when they are available. For example, it would be

inappropriate to use the CAPM and APTto value an office building when a suitable

comparable office building exists.

Tracking Error Considerations

The tracking portfolio metaphor may be useful in determining the best valuation

approach. The Capital Asset Pricing Model argues that every investment should be

tracked with a weighted average of the market portfolio and a risk-free asset. Tracking

¹⁴In

the early 1980s most major oil firms continued to explore for oil despite these price signals from

the market. As a result, many of these firms were taken over in order to end the unprofitable exploration

in which these firms were engaged. See Chapter 20 for further detail on this.

Grinblatt920Titman: Financial	III. Valuing Real Assets	12. Allocating Capital and	© The McGraw920Hill
Markets and Corporate		Corporate Strategy	Companies, 2002
Strategy, Second Edition

Chapter 12

Allocating Capital and Corporate Strategy

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with the CAPM has to be highly imperfect considering the dissimilarities between a

particular office building and the market portfolio. Financial analysts who use the

CAPM to value a real asset rely on the insight that the CAPM-based tracking error has

a zero present value to conclude that the valuation is correct. If the CAPM as a theory

is untrue in certain circumstances, this conclusion is unwarranted. We already know

that the tracking error does not have zero present value for stocks with low market-

to-book ratios, small market capitalizations, and high past returns. Thus, there is no

reasonto have similar confidence in the tracking error for any particular investment

project.

In contrast, the cash flows from a portfolio composed of a comparable office build-

ing and the risk-free asset tracks the evaluated building’s cash flows more closely than

a combination of the market portfolio and a risk-free asset. In either case, there is no

theoretical reason to believe that the tracking error will have zero present value. How-

ever, one obtains a better present value by using the comparable office building in a

ratio comparison than by using the CAPM if the tracking error with the comparable

office building is so small as to be negligible.

Other Considerations

While the ratio comparison approach and the competitive analysis approach seem easy

to implement and implicitly account for the strategic options embedded in most proj-

ects, they are limited by the degree to which the comparison investments and firms

exhibit rationality, either in their pricing (for example, in the price/earnings approach¹⁵)

or in their behavior (for example, in the competitive analysis approach). Moreover, it

may be difficult to ensure that the comparison investment (or firm) is truly an appro-

priate comparison and to take into account all factors for which there are differences

between the comparison entity and the project.

The practical focus we emphasize here suggests that using any single approach dis-

cussed in this chapter need not preclude a manager from also valuing a project with a

second method when it is practical to apply an alternative. Indeed, it probably makes

sense to value major investment projects using two or three approaches.