You probably need to format the external drive first. Launch "Disk Utility" (in the "Utilities" menu after you select a language when booted from your OS X install CD/DVD) and highlight your external hard drive. Click the "Partition" pane, select 1 partition (or whatever suits your fancy), then select "Mac OS Extended (Journaled)" and click "Partition".
Quit Disk Utility, and the disk should now show up as a valid install location.
Be aware that this procedure erases everything on the external hard drive, so ensure that the data that is currently on the external hard drive is backed up somewhere else.




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