Business Analysis and Valuation - America Online - Essay Example

Business analysis and valuation Institution Date Introduction America Online, Inc. (AOL) has been a leading provider of online services around the globe. It was discovered in Vienna and became a leader in establishment of new mass medium, which entailed online services, multimedia, internet and other interactive technologies. America online, Inc. also provided its members with a wide range of features, such as electronic mail, real-time talk, electronic news papers and magazines, internet access and online shopping and classes. As a way of expanding, America Online Inc. involved in other businesses, such as interactive marketing and transactions abilities, and networks so as to support data transmission. AOL obtained its revenues mainly from consumers’ membership fees, content providers and merchandisers. To understand this company fully, it is essential to analyze and evaluate essentials information relating to its financial statement. This paper therefore seeks to analyze and evaluate America Online Inc. by conducting business strategy analysis, accounting analysis, financial analysis, forecasting analysis and valuation analysis. Business strategy Business strategy analysis is an essential starting point for assessing any financial statement of a company. It normally permits analysts to evaluate the firm’s economics at qualitative level so as to enable the accounting and financial analysis to be based within business reality. Business strategy analysis also assists in identification of a firm’s profit drivers and essential risk. This in turn normally assists in analyzing the sustainability of the current performance of a firm and develops realistic predictions for future performance. Strategy analysis normally entails industry analysis, competitive strategy analysis and corporate strategy analysis. Therefore, to conduct business strategy analysis in America online Inc. it will be essential to analyze its industry, corporate strategy and competitive strategy. Online consumer services industry is dominated by three main firms. These firms include America online, CompuServe and Prodigy. These firms serve almost 8.5 million of the prevailing subscribers. Among the 8.5 million subscribers, 4.0 million subscribers are served by America online, 2.8 million subscribers are served by CompuServe and 1.6 million are served by Prodigy. The market therefore for online consumer services is oligopoly one and has successfully worked as middlemen among thousands of content providers and millions of customers. America Online, CompuServe and Prodigy are believed to be publishers who keenly control the product and who pays content providers and writers modest royalties. However, with the introduction of internet World Wide Web and the establishment of Microsoft network, content providers currently have optional channels that greatly control their products and provide higher revenues. Palepu (2007) argues that profits of an industry are normally determined by the amount of money customers are willing to provide for industry’s product or service. The main determinant of price is the level of competition among the providers of similar services or goods. It is believed that if a market is perfectly competitive, prices will be equal to marginal cost and the chances of making supernormal profits will be low. On the other hand if the market is an oligopolistic there will be a high chance of making abnormal profits. For America online Inc. there is a high chance for it to make abnormal profits in the short run, since the industry operates in an oligopolistic market. As compared to CompuServe and Prodigy, America Online Inc. occupies a large market share, thus making it a price leader. Being a price leader therefore makes it able to charge prices that will ensure the company earns abnormal profits. However, with the entrant of Internet World Wide and Microsoft Network, America Online profitability will reduce. In several industries, the degree of profitability is normally determined by the nature of competition that prevails among firms in the industry. In some industries, competition among firms is normally too high, thus pushing the prices below the marginal cost. In other industries, firms do always avoid competing aggressively on price and instead, they engage in coordinating their pricing or involve in non-price competition. For America Online Inc. case, there are very few competing firms in the market. This therefore implies that the few firms, which are America online, CompuServe and Prodigy, can easily cooperate and avoid destructive price competition. The absence of competition therefore in the industry, allows America Online Inc. to earn high profits. The presence of new entrants in the market also illustrates the ability of America online Inc. to make abnormal profits. The entrant of Internet World Wide Web and Microsoft Network in the industry is a clear indication that firms in the online consumer services industry are making abnormal profits. According Palepu (2007), the ability to earn abnormal profits normally attracts new entrants in the industry. For a long period of time, the ability to reach cyberspace browsers has always been through one of the three dominant online services, which are America Online, Prodigy and CompuServe. Of late, this has not been the case. The entrant of Microsoft has threaten to fade the oligopolistic advantages enjoyed by the big three online services. Therefore, with the new entrants in the industry, America Online will find it hard to degenerate its return on equity to its cost of capital. Accounting From AOL’s accounting, it is quite clear that since 1993, the company’s total revenues have been increasing. Similarly, the total costs and expenses for America Online have been increasing since 1993. In 1993, America Online had total revenues of $51,984,000 and the total costs and expenses of $50, 059,000. The revenues in 1994 for America Online increased to $115,722,000 while its total costs and expenses increased to $111,114,000. In 1995, the total revenues further increased to $394,290,000 while total costs and expenses increased to $413,584,000. Therefore, the increase in total costs and expenses made America Online to experience a very low gain from its operations in 1993 and 1994. The low gains in these years were $1,925,000 and $4,608,000 respectively. In 1995, America online experienced a loss of $19,294,000 from its operations. The low gains and losses experienced by America Online are due to the new entrants in the market. New firms in the industry, such as Microsoft, have made America Online to incur more costs and expenses so as to keep up with the prevailing competition. In the financial year ending June 30, 1995, America Online recorded a loss of $33.6 million on revenues of $394 million as compared to the previous year’s profit of $2.5 million on revenues of $116 million. The new costs that were introduced for the first time in 1995 incorporated $50.3 million for acquired Research and development (R&D), $2.2 million in merger costs and $1.7 million amortization of goodwill. The total revenues in America Online have been high due to the increased number of new subscribers. The number of new subscribers has been increasing by 233 percent every year. It is believed that in future the number of subscribers will reduce. This is because majority of subscribers will prefer migrating to a higher-speed access. America Online therefore decided to introduce a heavy-usage pricing so as to respond to lower per hour pricing of Microsoft. This however will further impact negatively on the firm’s profitability. Financial analysis Financial analysis in any business can be done through undertaking cash flow analysis. Cash flow analysis refers to evaluation of cash flows and outflows of a business. It normally entails observation of the components of a business that affects cash flow. These components include inventory, accounts payable, accounts receivable and credit terms. In America Online, cash flow can easily be determined by deducting cash out flow from cash inflow. By doing this the company’s performance can easily be determined. A positive cash flow implies good performance while a negative cash flow implies poor performance. The AOL’s consolidated statements of cash flows depict a positive cash flow since the year 1993. In the years, 1993, 1994 and 1995 America Online Inc. had cash flows of $10,163,000, $43,891,000 and 45,378,000 respectively. By considering the magnitude of cash flows in these years, it can be concluded that in the past, that is, in 1993, the performance of America Online was not very good as compared to the performance in 1994 and 1995. The amount of cash inflow in 1993 exceed cash outflow by smaller margin as compared to the amount of cash flows in 1994 and 1995. This therefore implies that in the past America Online Inc. was performing poorly as compared to current performance. Currently, that is, in 1995, America Online experienced the greatest cash flow of 45,378,000. This implies that its current performance is extremely good as compared to past performance. With the steady increase in cash flows, the company will be able to sustain itself. Forecasting Based on the past trends, the assets and liabilities in the balance sheets will generally increase in future. By considering the cash flows statements, it is evident that in 1995, assets and liabilities were adjusted by a positive amount of $49,538,000. This had an effect of increasing assets and liabilities in the balance sheet. Therefore, in future, the assets and liabilities of America Online Inc. will increase. The proceeds from issuance of common stock have been increasing since 1993. This will cause the stockholder’s equity and cash and equivalents to increase in the balance sheet. In the income statements, by considering the trends of total revenues, it is evident that the revenues will be higher in the future. The quarterly information depicts that the total revenues of 1995 fiscal year was $394,290. In 1994 fiscal year, the total revenue was $115, 722. Therefore, by following this trend, it is evident that in future the total revenues will increase. It can be predicted that the total revenues of America Online Inc. will be high in future. However, even though the company will experience higher revenues in future, it will experience losses. From the income statements, in 1994, the company experienced a net income gain of $2,550. However, in 1995, the company experienced a net income loss of $33,647. The net loss was too huge as compared to the net gain in 1994. This therefore implies that the company will continue to incur the losses in future. Valuation By using residual income model, the value of a firm in 1994 will be Net income – cost of equity= 2550-0.07= 2549.93 In 1995, the value of a firm will be -33647+0.99= -33645.02 In 1994, America Online generated a positive residual income on shareholder’s perspective. However in 1995, the company was economically unprofitable. The company was therefore unprofitable in both accounting basis and shareholder’s perspective. Conclusion From the discussion, it is clear that America online, CompuServe and Prodigy are the firms that dominate online consumer services industry. The firms serve almost 8.5 million of the prevailing subscribers. Among the 8.5 million subscribers, 4.0 million subscribers are served by America online, 2.8 million subscribers are served by CompuServe and 1.6 million are served by Prodigy. From AOL’s accounting, it is quite clear that since 1993, the total revenues, total costs and expenses for America Online have been increasing. The low gains and losses experienced by America Online are due to the new entrants in the market. It is also evident that by basing on the past trends, it can be predicted that the assets and liabilities in the balance sheet will increase. By following the trend in quarterly information provided, it can be predicted that the total revenues will continue to increase in future. When residual income model is used to determine the value of a firm, a negative residual income is displayed in the 1995 fiscal year, while a positive residual value is displayed in 1994 fiscal year. References Palepu, K., (2007). Business Analysis and Valuation: Text Only. New York: Cengage Learning EMEA. Read More