How Valuation is Really done, and what use is that Valuation model in M&A deals?

Two stories: In the early 80s, GM bought EDS (Electronic Data Systems). In the weeks before the acquisition was announced, an analyst in the Treasurer’s office at EDS was summoned by the CFO and asked to ‘model’ the share price of EDS. The analyst was a bit perplexed – after all, one could look up the share price in the Wall Street Journal (no internet in those days, remember).. but he did as he was bidden, sat down on his PC (IBM XT, I think it must have been in those days, and Lotus 123, not Excel) and put numbers into his spreadsheet that would justify the share price at the time - $25 or so. Took it to his CFO – CFO shook his head and gestured upwards with his thumbs.. back the analyst went to his PC, changed a couple of numbers in the projection and came up with $35. Surely the CFO would be happy now? No, he got the same response. But, by now, the analyst had gotten smarter too – he asked the CFO what he should have asked him in the first place – ‘what number are you looking for?’. The CFO told him - $44. Well, it didn’t take long to conjure up $44 on the spreadsheet – the CFO pronounced himself satisfied and took the spreadsheet up to the executive floor to show the CEO and Chairman and the rest of the bigwigs. When the acquisition was announced, at $44, our analyst naturally felt pleased – but he also wondered how the CFO knew the answer.. turns out he didn’t, it was just his best guess of what GM would be prepared to pay. Imagine the feelings of both the CFO and the analyst when it was later revealed that, the same day, there was a gentleman from GM in the building with an authorization his pocket from GM’s chairman, to pay $50 a share! Story number 2: I was once involved in a merger of equals (no names this time). There were 4 people present in the room – myself, the chairman of the acquiring company, and two senior executives representing the company to be acquired. The opening remark from one of these senior executives was – the two companies are pretty much the same size, aren’t they? So shall we just value them as equal? We all looked at each other and nodded – it took about 5 seconds for the valuation to be done! Needless to say, some Big $ company was given a huge fee to do the valuation, after the fact, of course – their role was to justify the number we had already agreed on. The fact is, valuation is explicitly a matter for negotiation – it is decided by negotiation, by each side trying to figure out what the other side will go by. There are excel sheets and ‘times revenue’ models and ‘P/E’ models, but they are all really just rules of thumb, to make sure the negotiation is not just going way off base. So is the valuation model useless? Why do I teach it to everyone as an essential tool of finance? For that, we need a third story: During the negotiation of several (not just one) of the acquisitions I have been part of, it is useful to have some basis for negotiation. If I say the company is worth 10 and the target company says it is worth 20, how do we converge? Should we just split the difference? What I usually do is pull out my excel spreadsheet and say, all right, let us see what it would take to justify 20 – pretty soon, it becomes obvious that, to justify a price of 20, the company would have to do something extraordinary and unprecedented, like achieving double the margins it normally manages, or growing twice as fast as it ever has in its history. Then the negotiation can begin – the point is, now we have something to discuss, other than ‘10’ or ‘20’.. the spreadsheet serves as a very useful negotiation tool. It is nothing more than that, but nothing less, also... is it useless? No. But is use is not what people think.