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Gap Inc. Equity and Valuation Analysis
As of June 1, 2007
Eulogio Ruiz Jr.
[email protected] Kendala Sheffield
[email protected] Chelsey Price
[email protected] Melisa Hudman
[email protected] Trey Keith
Gap Inc.
Table of Contents Executive Summary………………………………………………….. 4
Business and Industry Analysis…………………………………… 9
Five Forces Industry Analysis……………………………… 11
Rivalry among Existing Firms……………………………………… 12
Industry Growth Rate……………………………………….. 13
Concentration…………………………………………………. 13
Differentiation………………………………………………… 16
Switching Costs………………………………………………. 17
Scale/Learning Economies………………………………… 17
Fixed Variable Costs…………………………………………. 19
Threat of New Entrants…………………………………………….. 20
Economies of Scale………………………………………….. 20
First Mover Advantage……………………………………… 21
Channels of Distribution and Relationships…………… 22
Legal Barriers…………………………………………………. 22
Threat of Substitute Products…………………………………….. 23
Bargaining Power of Buyers……………………………………….. 24
Price Sensitivity……………………………………………….. 24
Relative Bargaining Power…………………………………. 25
Bargaining Power of Suppliers……………………………………. 25
Price Sensitivity………………………………………………. 25
Relative Bargaining Power………………………………… 26
Value Chain Analysis………………………………………………… 27
Brand Image…………………………………………………... 28
Research and Development……………………………….. 28
Customer Service…………………………………………….. 28
Tight Cost Control……………………………………………. 29
Gap Inc.
Table of Contents Competitive Advantage Analysis………………………………. 29
Brand Image………………………………………………... 29
Research and Development…………………………….. 30
Customer Service…………………………………………. 30
Tight Cost Control………………………………………… 31
Accounting Analysis……………………………………………… 31
Key Accounting Polices…………………………………………. 32
Brand Image………………………………………………. 32
Research and Development…………………………… 33
Marketing………………………………………………….. 33
Customer Service………………………………………… 34
Tight Cost Control……………………………………….. 34
Accounting Flexibility………………………………………….. 35
Accounting Strategy……………………………………. 37
Quality of Disclosure…………………………………………… 39
Qualitative Measures………………………………….. 39
Quantitative Measures………………………………… 41
Identifying Potential Red Flags…………………………….. 47
Undo Accounting Distortions………………………………… 48
Financial Analysis………………………………………………. 49
Liquidity Analysis and Ratios……………………….. 50
Profitability Analysis………………………………………….. 56
Capital Structure Analysis…………………………………… 62
Internal and Sustainable Growth Rates…………. 66
Other Ratios…………………………………………….. 68
Forecasting Analysis………………………………………….. 70
Balance Sheet Forecasting Analysis………………. 73
Gap Inc.
Table of Contents Cash Flow Forecasting Analysis………………….. 76
Method of Comparables……………………………………. 78
Free Cash Flow Valuation Model…………………………. 86
Discounted Dividend Valuation Model…………………. 87
Residual Income Valuation Model………………………. 88
Long-run Residual Income Perpetuity…………. 90
Sensitivity Analysis…………………………………………. 91
Abnormal Growth Model…………………………………… 92
Atman Z-Score……………………………………………….. 93
Appendices……………………………………………………. 95
References…………………………………………………….. 103
Executive Summary Table
Investment Recommendation: Overvalued, Sell 06/01/2007
GPS - NYSE Share Price
(6/1/07): 18.51 EPS Forecast 52 Week Average: 18.45 2007 2008 2009 2010 2011 Revenue 15.9 million $832.77 $891.40 $954.15 $1,021.33 $1,093.23
Market Capitalization 15.65 Billion
Shares Outstanding 821,837,000 Ratio Comparison GPS AEO ANF
Percent Institutional Ownership 58.3% Trailing P/E 15.13 15.13 16.72 Book Value of Equity: 5,174,000 Forecasted P/E 12.47 12.09 12.84 ROE: 14.34% PEG 0.83 0.79 0.86 ROA: 8.82%
Cost of Capital R2 Beta Ke Share Price (6/1/07) 18.51
Estimated 0.26 1.64 11.3 3-month 0.26 1.63 P/B 4.58 6-month 0.25 1.64 EV/EBITDA 7.34 2 year 0.25 1.62 P/EBITDA 0.07 5 year 0.25 1.62 P/FCF 0.0011 10 year 0.25 1.61 Kd 6.9 WACC: 11.02 Intrinsic Values Estimated Actual Altman Z-Score FCF $ 4.99 18.51 2002 2003 2004 2005 2006 R.I. $ 2.82 18.51 2.84 3.26 3.72 4.23 4.16 AEG $ 7.74
Executive Summary Business Overview
Gap, Inc. is one of the most well known companies in the specialty
apparel industry. They operate under five different store names in 909 different
locations. These different store names include Piperline, Forthe and Towne, and
the better known Gap, Banana Republic, and Old Navy. Each of these stores
offer different styles of clothing and one might not know they all coexisted under
Gap, Inc. Gap first opened the doors of its first store in 1969 and since then has
begun to compete with stores such as Abercrombie and American Eagle.
In the specialty apparel industry, it is important to know that you must
compete under both product differentiation and cost leadership. Your product
and brand name differentiation keeps your customers coming back to you. It is
important for your customers to trust that you have the latest, “coolest” styles.
Therefore, you must stay on top of the learning curve. The cost leadership
strategy is important when your customers can easily go to the next shop. You
need to keep costs down, so you can offer the best product at the best price.
This intern will keep you existing customers as well as attract new one.
In the industry, the rivalry amongst existing firms is extremely high due to
the amount of effort firms are forced to exert in the differentiation strategy
through brand image and concentration. While you must worry about big firms
in the industry, new firms with small asset bases are nothing to be concerned
about. They just cannot compete in the big times. Threat of substitute
products and bargaining power of buyers are both moderate, while the
bargaining power of suppliers is relatively low. The vast number of resources
the companies could use is limitless in all parts of the world. There are so many
suppliers to use; the suppliers have virtually no power in the industry.
Accounting Analysis
10-K’s are annual reports required by the SEC to be published each year.
These reports are generally sent in good form to the investors and are publicly
available to any potential investor. We gathered most of the numbers used to
compute this analysis from the 10-K of Gap, American Eagle and Abercrombie.
To run this analysis, we did wide-ranging ratios which took into account the
Statement of Cash Flows, Balance Sheet and Income Statement. The ratios we
computed let us know what was going on within the company for the past 6
years. It was important to go back several years to analyze trends and
significant changes. When accounting abnormalities occurred we were able to
easily find them. While we did not find many significant, or changeable, “red
flags” the net sales to inventory concerned us. While other competitors ratio has
been shrinking Gap, Inc.’s ratio is growing. It is a concern when the company
you are valuing is contrasting from the industry average significantly with no
justification.
Financial Ratio Analysis
We used Financial Ratio Analysis to analyze Gap, Inc. relatively to
Abercrombie and American Eagle, its competitors. There are three main parts to
this segment of ratio analysis. These include the liquidity, the profitability, and
the capital structure sections. Each segment is important because they each tell
us something different about the company. Our liquidity ratios are seven ratios
that show Gap, Inc.’s ability to pay off debt that is coming due. The profitability
ratios show Gap, Inc.’s sales, profit, and asset efficiency. There are six of these
ratios. The profitability ratios help creditors analyze credit risk. Moreover, some
of these ratios are used in the Z-Score equation to compute the company’s credit
score. The capital structure analysis shows different methods of financing of the
firm. It shows its ability to pay of interest and maintain their Z-Score.
Other ratios that we used included property, plant, and equipment
turnover, as well as, operating cash flow. We felt that property, plant and
equipment were relevant to this analysis because this account is one of the most
important assets the firm has. It helps us understand how much the company is
investing over the year into PP&E. We considered operating cash flow as well
because it shows us just how quickly a company can come up with money to pay
off short run liabilities.
After completing all of the ratios, we used them to forecast out financial
statements up to 2016. An important step in comprehending what Gap, Inc. is
going to be worth in the future was to understand how their financial statements
were going to change over the years. However, Gap was not very well organized
in their trends from year to year. This made it difficult to forecast for this
company.
Intrinsic Valuation Models
The Intrinsic Valuation Models all come up with an “intrinsic” share price.
This estimate is based on present values of different numbers for each model.
There are five models that we analyzed. They include the (1) Free Cash Flow
Model, (2) Discounted Dividends Model, (3) Residual Income Model, (4) Long
Run Residual Income Perpetuity, and (5) Abnormal Earnings Growth Model.
Each of these either used Gap, Inc.’s WACC or Ke to come up with the intrinsic
share price. The intrinsic share price tells us what the share price should be if
you isolate the information given from external factors. In order to calculate the
intrinsic share price the first method was to compute WACC, Ke, and Kd for Gap.
Kd was given in the financials where Ke was a product of regressions ran for
Gap, Inc.’s historical stock prices. WACC was computed using the traditional
formula and done on a before tax basis.
Each one of the intrinsic valuation models was relatively close in
comparison of the intrinsic share prices when looking at the sensitivity analysis.
However, only one came close to the actual share price of Gap, Inc. This one
was the Free Cash Flow Model and it was within the 15% accuracy range only
when cost of equity was equal to zero. This means the share price through this
model is only realistic when the investors demand no return on the money that
they put into the company. This theory violates the definition of investing. We
observed a share price of $18.51 on June 1, 2007. When we took the value of
the firm based on our five valuation models we came up with intrinsic share
prices in a lower range. This shows how overvalued Gap, Inc. really is,
especially when each model came up with around the same number. This is
important because each model used different ratios or assumptions and they all
said the same thing. The Free Cash Flow Model came up with an intrinsic share
price of $12.56. The Discounted Dividends Model estimated the share price to
be $6.94. The Residual Income Model is estimated at $7.00. The Long Run
Residual Income Perpetuity depends on the growth rate, return on equity, and
the Ke. Using a ROE of .3 and .12 for the Ke this model gave us a Price of 46
cents. This was shows that Gap was fairly valued. Playing with different
numbers and scenarios gave us different interpretations of where Gap Inc.
stands.
As the models have shown, Gap, Inc. is overvalued and we recommend
selling the stock as of June 1, 2007. After discovering that through the models
we found Gap’s credit worthiness through Altman’s Z-Score formula, which is
what corporations use to read their credit scores. Every year after 2002, we
found that the Z-Score was above three and this indicates that Gap Inc. is
considered to be a low credit risk. The higher the Z-Score means that the
company will be better off to pay their debt.
Business and Industry Gap Inc. was first found in 1969 by Donald Fisher, and has been around
ever since, expanding throughout the world. “We are a global specialty retailer
operating retail and outlet stores selling casual apparel, accessories, and
personal care products for men, women and children under the Gap, Old Navy,
Banana Republic, and Forth & Towne brands. We operate stores in the United
States, Canada, the United Kingdom, France and Japan.” (Gap Inc. 10 K 2006)
We have discovered that Gap Inc. focuses on different types of customers
through different operating stores, but they specialized on the brand recognition
to maintain loyal customers. Gap’s casual apparel are of quality, style, and mid
range prices for those customers that feel a since of pride with named brands.
Gap now operates 3,131 stores and also sells online at gap.com,
bananarepublic.com, oldnavy.com, and piperlime.com.
Some of Gap’s competitors include: Abercrombie & Fitch Co. (ANF) and
American Eagle (AEO). These two companies are the top competitors for Gap
Inc. However, Abercrombie only operates 950 stores to Gap’s 3,131 stores.
Abercrombie also has operating stores in the U.S., Canada, and the United
Kingdom. Abercrombie as well as Gap are now selling online in order to try and
raise the competition. American Eagle operates 906 stores and has a target
market from ages of 15 to 25 which gives Gap an advantage since they have
apparel for newborns to men and women of about 35 years. All of these
specialty companies have very similar products at very similar prices which do
not drive these companies into price wars. Price wars are driven by national
sectors like, Wal-Mart and Target. Since these companies have substitutes at
lower prices, customers sometimes tend to want to try out the bargains of Wal-
Mart and Target stores. We discovered that Gap invests lots of money in
research as innovators to specialize in the name brands, quality, and styles to
keep up with competitors and bring in new customers, as well as maintaining
loyal customers.
Industry Analysis
Gap leads the apparel industry because it is one of the largest retailers in
the United States and is expanding throughout the world. Its size gives Gap one
of the biggest advantages compared to competing industries. As you can see
below the data for Gap appears in the millions whereas Abercrombie’s is
displayed in thousands.
Gap Inc. ( In Millions)
2001 2002 2003 2004 2005 2006
Assets 7682823 9902 10713 10048 8821 8544
Sales 13378 14455 15854 16854 16023 15943
Abercrombie (In Millions)
2001 2002 2003 2004 2005 2006
Assets 1047 1173 1383 1386 1789 2248
Sales 1345 1595 1707 2021 2784 3318
Successful retailers have to make sure and keep up with fashion trends
and be ready for different times of seasons. Most of sales and profits occur at
different parts of the seasons. “Our business follows a seasonal pattern, with
sales peaking over a total of about 13 weeks during the Back-to School (August)
and Holiday (November through December) periods. During fiscal 2005, these
periods accounted for approximately 32% of our net sales” (Gap Inc. Annual K
2006). It is important to focus on this time period since it is crucial to the
continuing success of a firm in this industry. Employees must be dedicated and
inventory shipments must be timely in order to keep net sales high in these 13
weeks. During the off season months, firms such as Gap, American Eagle, and
Abercrombie must understand how to cut expenses to maintain operating profits.
Gap sales have steadily risen every year from 2001 to 2004 and slowly
decreasing from 2005 to 2006. Abercrombie has also been rising in sales from
2001 to 2006 and it does not seem like it is slowing down. Therefore, if
Abercrombie expands it stores and continues to open more stores then Gap
could lose some potential sales.
Gap has not been very strong in the stock market and prices have not
been very high. Abercrombie seems to have the advantage in the stock market
since they have been more profitable on their earnings per share. Abercrombie’s
earnings per share have been increasing at a steady rate while Gap seems to be
at a down fall (www.finance.yahoo.com, Abercrombie 10K 2006).
Gap has entered into a franchise contract with Malaysia and Singapore to
keep expanding through the world as an attempt to keep ahead of its
competitors. Forecasts seem prosperous since Gap’s apparel specialty industry is
so huge. Gap Inc.’s operating stores include: Gap, Old Navy, Banana Republic,
and Forth and Towne. Gap’s online selling websites have also helped Gap grow
so big. Their focus on mid-prices and high quality apparel, and styles help them
maintain their customers and stay ahead of competitors.
Five Forces Model The five forces model is a framework used in the analysis of industry
structure and profitability. This model is a comprehensive review of the industry
in that it evaluates the ability of firms to assess their standing in the industry.
When managers of firms realize what is important to their firm’s success by
utilizing the five forces model, they are able to easily recognize when
improvements need to take place to maintain their hold on market share.
Understanding the industries in which firms operate is essential for any firm to
be successful. “With a clear understanding of where power lies, you can take fair
advantage of a situation of strength, improve a situation of weakness, and avoid
taking wrong steps” (www.mindtools.com). The first three elements of the five
forces model are rivalry among existing firms, threat of new entrants, and threat
of substitute products. These elements analyze the degree of actual and
potential competition in an industry. The other two elements are bargaining
power of buyers and bargaining power of suppliers which use price sensitivity
and relative bargaining power to analyze bargaining power in input and output
markets.
Five Forces Summary Force: Level:
Rivalry Among Existing Firms High
Threat of New Entrants Low
Threat of Substitute Products Moderate
Bargaining Power of Buyers Moderate
Bargaining Power of Suppliers Low
Rivalry among Existing Firms
Many industries, including the specialty apparel industry, have high rivalry
among existing firms. Identifying and being knowledgeable about competitors,
and how to overcome obstacles that their competitors place on firms is essential
in highly competitive industries. It would be ideal for managers to not have to
deal with rivalry in their industry but this is rarely the case. If the competition
was low amongst existing firms, firms would have no difficulty holding their
market share in this industry. The firms within the placid industry would not be
motivated to maintain constant growth because it would not be necessary for
firms to open new stores or differentiate themselves. Companies in the specialty
apparel industry “compete with national and local department stores, specialty
and discount store chains, independent retail stores and internet businesses that
market similar lines of merchandise.”(Gap, Inc. 10K) With Target and other
clothing retailers producing a low cost alternative, specialty retailers must
maintain a superior brand image. Other than superior brand image, competition
in this industry amongst existing firms leads to the need for companies to
saturate the market and be easily recognizable. Since the specialty apparel
industry is highly competitive amongst existing firms, firms in this industry must
focus on industry growth, concentration in their market, differentiation, switching
costs, economies of scale, and fixed/variable costs to maintain and/or gain their
market share.
Industry Growth Rate
Growing competition from existing firms and the high demand for
products is causing firms in the specialty apparel industry to expand. If firms did
not stay up with their growing competition they would fall short of reaching their
potential profits. Specialty retail stores have been progressively opening new
stores. Marketing analysis shows that over the past decade, people do not have
time to walk the malls and leisure shop. These retail stores which were once
primarily spaces in malls are opening more and more stand-alone stores. As
consumers become more time efficient and firms realize their target market is
shifting away from densely populated shopping malls, by opening stand-alone
stores, customers have easy entry and exit benefits allowing them to save time.
For example, the time saved by knowing exactly where you are going to shop
and not having to deal with traffic from other shoppers is now important to time-
conscious customers.
Not only is the market in the United States growing, Canada and Europe’s
specialty apparel stores have been expanding their claims to the market. The
need for firms to globalize in this day is now more important than ever due to
the increasing technological advancements. “Facing flat demand in the U.S.
stores, American clothing marketers are venturing into unfamiliar terrain
overseas” (WSJ “For US Firms a Global Makeover.) Existing firms in the industry
are forced to adapt to this growing trend of globalization or face the
consequences in losing market share. In this industry it takes keeping up with
the Jones’s or beating them there. Not only is the entire market place expanding
overseas, net sales have been increasing although at a declining rate in the
industry as shown on the graph below. In order to maintain their hold on the
market they must saturate the market with their image and new trends. Rivalry
is high among existing firms considering the fact that firms are forced to
compete in the global economy and industry growth has become such an
important factor.
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
Industry Sales Growth
Industry Sales Growth
Industry Sales Growth 5.60% 8.95% 5.74% 4.72% 4.38%
2002 2003 2004 2005 2006
Concentration
In the specialty apparel industry, there is a lot of competition to face.
Abercrombie and American Eagle are a few competitors to mention, as well as
Gap. With the industries expanding globally as described in the previous
paragraph, the market saturation is relatively low. There are many more
markets for the existing firms in the industry to enter, including new cities, new
provinces, as well as countries where these companies had no pre-existence.
For example, prior to all the passport restrictions, residents of Mexico were able
to freely cross the border to shop in the Rio Grande Valley as well as the San
Marcos outlet stores. These consumers do not have the luxury now to shop at
most specialty retail stores due to their location. Therefore, firms are moving to
specific locations to cater to these types of customers with boundary restrictions.
The main thing companies have to worry about with concentration is the
big name companies in the industry who have stores everywhere and hold a lot
of the market share as demonstrated below. This strengthens the need to
recognize opportunities to expand into these less saturated market areas and
further increases rivalry among existing firms.
Market Share Distribution based on sales for 2001-2006
Market Share 2001
83.50%
8.23%8.27%
GPS ANF AEO
Market Share 2002
82.53%
8.23%8.27%
GPS ANF AEO
Market Share 2003
83.08%
8.23%8.27%
GPS ANF AEO
Market Share 2004
80.62%
8.23%8.27%
GPS ANF AEO
Market Share 2005
75.83%
8.23%8.27%
GPS ANF AEO
Market Share 2006
72.29%
8.23%8.27%
GPS ANF AEO
Differentiation
When you are in a mall what is going to make people come into your
store rather than the next store over? What is going to make people come to
the stand-alone store down the street? Your product and experience will pull
customers in. How an individual perceives your product and others that wear
your product will determine whether or not he/she will shop in your store.
PacSun boomed over the period of a year (www.PacSun.com). Why? In 2005, it
was seen as “in.” People liked the product for the price and enjoyed their
experience there. Also on May 27, 2007, Gap Inc. was forced to hire a high-end
designer, Patrick Robinson (WSJ “Gap Hires a High End Designer.”) They did
this in an effort after loosing market share to already existing firms. The attempt
is to bring customer’s interest back on Gap’s unique brand and product image.
Product Differentiation is key in this highly competitive market. The firms in
operations must maintain their separate images. Ultimately there is a relatively
high threat of existing firms when considering the effort firms must exert in
brand image differentiation.
Switching Costs
Because customer switching costs in this industry are low, it is important
for firms to keep their costs low. Firms in the specialty apparel industry have the
option to outsource their inventory manufacturing or to provide this task in-
house. Some firms choose to use US manufacturing facilities and labor. In this
industry switching costs are low because it is easy for apparel companies to
utilize overseas manufacturers in order to keep costs under control. Overseas
labor is much cheaper than alternatives and it is important to keep costs under
control in order to maximize profits. Radley Balko says on Fox news in the story
Outsourcing Debate Tainted by Myths, Misconceptions that if one firm does not
take advantage of the cheap labor costs, the next firm will be able to take
advantage of the cheap costs and outdo their competition. In the specialty
apparel industry rivalry among existing firms is high because competitors know
using overseas manufacturers is a sufficient way to cut costs and every firm is
trying to manipulate the system in order to be the most efficient.
Scale/Learning Economies
Scale of economies is an important factor for specialty retail industry
firms. In order to overcome rivalry among existing firms, a firm in this industry
relies on size as a benefit to its success. Customers will usually choose to shop
at the store they know over a store they have never heard of and usually
customers know the larger stores as opposed to a small local store. If a
customer is walking through a shopping mall and sees a large well-known store
they are more likely to stop and shop there than they would be to stop at a small
unknown store. Customers also relate the size of a store to the product variety
they will have to choose from. The larger the store, the larger the selection of
items a customer will have to purchase and the chances of having to take time to
go to another store is minimized. The larger the firm the greater the chances
are they will be more widely known domestically as well as across international
borders. Having a large asset base will help firms achieve a desired size which in
turn will allow them to have a desired portion of the market share.
Total Assets
$-
$2,000.00
$4,000.00
$6,000.00
$8,000.00
$10,000.00
$12,000.00
2002 2003 2004 2005 2006
Year
Asse
t Bas
e (m
illio
ns)
GPS ANF AEO
In the specialty apparel industry the learning curve is extremely steep.
Everyone has to be on top of the latest style or trend. Each season their retail
products change- sometimes more than once a season. If you are not on top of
the learning curve you are likely to lose millions of dollars. To keep your
customers coming back the firms must have customers that trust them to know
and have the latest style. If your customer comes in and you don’t have it, but
the neighbor store does it instantly sends a message to the customer that your
clothes are not in style and the customer gains respect for another firm. Firms
keep their customers coming back to them rather than their rivals within the
industry by staying on top of the learning curve.
Fixed/Variable Costs
When comparing fixed and variable costs in the specialty apparel industry,
we have noticed several different types of cost. Fixed costs consist of the
building, upkeep of the building, and equipment. The fixed costs do not change
through out operations. The variable costs all depend on how much business
firms in the industry are supplying. The employees on the floor are a variable
cost. Most firms within this industry push a lot of merchandise around Christmas
and Back-to-School times. Starting the day after Thanksgiving, specialty apparel
industry firms have a peak season lasting until mid January. Also, August is a
peak month for firms in this industry because of back-to-school shopping and
tax-free day which normally occurs a week before school starts. They hire extra
workers around busy times to make operations go smoother. After the busy
time is over, the workers are dismissed. Along with the workers, the clothing
that is sold with each transaction is a variable cost. In the industry, there are a
lot of fixed and variable costs involved that influence their financial statements
and profitability. The costs must be kept under control to keep hold of market
share. In the extremely volatile market, maintaining costs relative to existing
firms makes rivalry higher.
Rivalry among existing firms is high in the specialty retail industry due to
necessary continuing growth in size and trends. Also, the need for differentiated
products and maintaining low costs lead to high competition in this industry.
Having a valid overall understanding of competitors in the industry and realizing
where potential opportunities for success are achievable, firms in the specialty
apparel industry will have a better chance to reach their desired goals before
their competitors.
Threat of New Entrants Entering a market where there already is tough competition can be a
difficult and daunting task. Firms that are willing to take the risk though, see
potential profit. Existing firms must entertain the idea of new entrants into their
industry. If new firms enter the market, they will try competing with the existing
firms on many levels. Being cost efficient would be one of the ways new
entrants would try to enter. New firms will have to go through different barriers
already set in place to enter the market. New firms will use such barriers as:
economies of scale, first mover advantage, access to the channels of distribution
and relationships, and legal barriers. They will use this to help justify their
decision on whether or not there is profit to be made in the market. Existing
firms have to take the threat of new firms entering the market seriously and in
turn will evaluate the barriers as well. After evaluating the barriers of entry used
by firms there is a low threat of new entrants.
Economies of Scale
Gap is an experienced specialty retailer and competes at the highest level
in their industry, which is a disadvantage to the new firms. Existing, more
veteran firms have the upper hand with the economies of scale. Competing right
away with well established companies such as Gap, Abercrombie and Fitch, and
American Eagle is near impossible. To compete with these large companies,
money and resources are the main factor. Gap, along with Abercrombie and
Fitch own multiple chains which helps them keep control of the majority of the
economies of scale. New entrants have no choice but to invest large amounts of
money into a very large industry, where they will at first be operating at less
than full capacity. While the new companies are suffering, existing firms will be
operating at full speed, giving them the advantage. Existing firms have the
resources to out research develop and out advertise their newly, weakened
opponents. The table below shows total assets in millions of dollars for Gap,
American Eagle, and Abercrombie and Fitch. These numbers show the large
amount of resources available for these firms to compete in an industry where
size is a key component. While the total assets fluctuate between firms, it is still
necessary to hold a high amount of total assets in order to be a valid competitor
in this industry.
Total Assets(millions) 2002 2003 2004 2005 2006
GPS $ 9,902.00
$ 10,713.00
$10,048.00
$ 8,821.00
$ 8,544.00
ANF $ 994.82
$ 1,383.23
$ 1,347.70
$ 1,789.72
$ 2,248.07
AEO $ 741.34
$ 932.41
$ 1,293.66
$ 1,605.65
$ 1,987.48
First Mover Advantage
First mover advantage can be difficult to achieve in the specialty retailer
market. For example, a company such as Target trying to move into the
specialty apparel industry would be difficult because firms in this industry already
have a well-established market line and Target is not known for having products
as unique as existing firms in this industry. The retail industry is overloaded with
various types of retail products and apparel and is flooding the market. The
firms trying to distance themselves from the competition have their work cut out
for them because the market is already well diversified. Various firms have
unique product lines already in place to take away from the first mover
advantage. The new firms trying to gain some of the market will have to try to
target new audiences with new ideas. One of the ways is adding new
departments for a specific type of group. Abercrombie and Fitch is an example
of this by adding an Abercrombie and Fitch Kids brand which brings in a whole
new cliental. By targeting new customers the firm will have a first mover
advantage over their competitors. Other firms will focus on the attention to
detail aspect. Having good customer service will help separate firms from each
other and thus getting an advantage. In the specialty retail industry having any
kind of advantage over the competition will be a key to their success.
Access to Channels of Distribution and Relationships
In the specialty apparel industry, having good access to a reliable channel
of distribution can make or break a company. As previously mentioned, during
peak seasons companies need to be able to rely on their distributors and
suppliers to keep their consumers loyal. In order to have these reliable sources,
firms must find the best options providing the lowest costs and then create
lasting and secure relationships with these relevant sources. For example, firms
want to be top priority to manufacturers in order to meet their demands. New
firms will have to find and then create relationships with suppliers and
distributors. Existing relationships between firms and customers in an industry
also make it difficult for new firms to enter an industry (Business Analysis and
Evaluations 3rd edition pg. 2-4). Because of the existing relationships and
ongoing business already in progress, manufacturers are less likely to create new
relationships which make threat of new entrants low.
Legal Barriers
There are virtually no legal barriers when entering the retail industry.
Anyone can basically come into the retail industry and set up shop. One of the
only legal barriers that have to do with the retail industry is trademarks. When
setting up your own trademark it has to be different than other firms due to legal
ramifications. Another legal barrier firms might run into is employee problems.
Providing a safe working environment is vital to avoid certain legal issues.
Threat of new entrants is low in the specialty apparel industry when you
consider all of the obstacles set by already existing firms. It is virtually
impossible for a firm to jump into the industry with a million dollar asset base,
which still does not compare to the veterans in the industry. The mom and pop
shops of the apparel industry may be able to make their profits but do not
compete with the big dogs.
Threat of Substitute Products
The threat of substitute products in the specialty retail industry is always
on the mind of the firms. Most of the companies have to induce buyers on price.
Some customers are brand loyal, but when it comes down to choosing a product,
it comes down to price. Customers do not incur any switching costs so it does
not cost them anything to be brand loyal or not. When it comes down to it, the
specialty retail industries are just clothes which can be substituted for other
clothes. The larger companies can compete on low cost with image. Such large
companies who do this are Abercrombie and Fitch and American Eagle. The
threat of specialty store substitutes is the smaller stores who are solely brand
conscious. They are a substitute threat because advertising comes into effect.
Ultimately, there is a moderate threat of substitutes when considering switching.
Bargaining Power of Buyers
Customers in the apparel industry have many options when shopping for
clothing. Some customers are mostly concerned with low cost, while others care
more about quality and are willing to pay a little more for products. Firms in this
industry must try to cater more specifically to customer’s demands or try to focus
on quality and low cost. Being a competitive industry, firms must strive to stand
out from their competitors in order to attract customers.
Price Sensitivity
In the specialty apparel industry switching costs for customers are very
low. Customers are easily able to shop elsewhere with little or no switching costs
and purchase fairly undifferentiated products. With Gap Inc. having Old Navy,
Gap, and Banana Republic stores, they have a fairly large customer base by
offering clothing for different age groups. Losing customers here and there does
not necessarily hinder a firm’s profitability because while brand image and
customer loyalty are important factors, there will always be the next first-time
shopper willing to purchase a firm’s products. This gives customers in this
industry moderate bargaining power.
In the apparel industry there is always a neighbor with a product for the same
purpose, to wear. Switching costs are very low for the customers, in fact if they
find a sale rack in a neighboring store they may never think about coming in
your store. Hence it is crucial to keep all customer related experiences good
ones. Customers are more likely to come back if they like the product and the
experience when purchasing the product. Therefore, customer service is another
critical game to include in this industry. If you provide a horrible experience to
your customers, your company as well as your brand name will lose value.
Marketing tests show it is cheaper to maintain an existing customer than attract
a new one. It is also shown that a customer with a bad experience in a store will
tell more people than those with a good experience. Avoiding bad experiences
with customers is crucial to keep from loosing them. Moreover, keeping the
image of the company clean is detrimental to a firm’s success, because of the
ease of buying the product somewhere else and low switching costs for the
customer.
Relative Bargaining Power
Since there is a large volume of apparel shops in the market, customers
are able to choose where they would like to shop based on their preferences.
Small volumes of products can be purchased from different apparel stores,
because each store will not offer exactly what customers are looking for. Even
though small quantities might be purchased by customers, everyone needs
clothing so this provides the firms in the industry an advantage and gives
customers moderate bargaining power.
Bargaining Power of Suppliers
In the apparel industry, commodities and undifferentiated products, such
as cotton, are purchased in the manufacturing of goods sold to customers. Also,
cheap labor is abundant overseas for manufacturing needed products. Switching
costs are low for this industry, allowing firms to easily pick and choose which
suppliers they would like to do business with since suppliers offer very similar
products, which gives suppliers in this industry low bargaining power.
Price Sensitivity
In the specialty apparel industry there are many textile companies to
choose from when looking for suppliers, therefore companies are able to pick
and choose which manufacturer best meets their needs. This drives suppliers
bargaining power down. With apparel manufacturing, cotton represents a large
portion of their manufacturing supplies, so firms are willing to consider supplier
prices a high priority. The only obstacle that could hinder a firm’s ability to use
some suppliers would be trade restrictions (Gap Inc. 10-K 2006). Labor in the
US is far more expensive than in foreign countries so many apparel companies
choose to outsource much of their manufacturing to countries outside of the US.
Throughout the years, the US government has continually tried to increase the
required minimum wage which pushes firms in the apparel industry to outsource
their manufacturing overseas. Overseas manufacturers with attractive labor
costs must remain competitive in order to have customers, which gives suppliers
low bargaining power relative to the firm.
Relative Bargaining Power
There are a large number of suppliers for the apparel industry. Retailers
have the opportunity to obtain their supplies from more than just one supplier.
In the case of Gap Inc., they use 780 different vendors around the world to
purchase merchandise from, giving Gap bargaining power. The major suppliers
are based in China, representing approximately 20% of merchandise, while the
rest is purchased from vendors in 50 other countries. Other firms in this industry
such as Abercrombie & Fitch also purchase their supplies from companies
overseas. Suppliers must compete for decent quality and low cost in this industry
because retailers want to have the cheapest costs of goods while also trying to
maintain quality. Due to the large number of suppliers in the apparel industry
and the need for the suppliers to be highly competitive with one another,
suppliers have relatively low bargaining power.
The specialty apparel industry has a high level of rivalry among existing
firms due to competitive firms trying to maintain growth and gain market share.
It is important to be a large firm and differentiate yourself from competitors in
this industry. Another reason rivalry among existing firms is high in this industry
is because firms must maintain low costs relative to their competitors. Threat of
new entrants in this industry is low because size once again an important factor
keeping potential firms from entering this industry. Also the first mover
advantage does not provide benefit to potential entrants and channels of
distribution are hard to achieve with the existing relationships that firms already
in the industry have. Threat of substitute products is moderate in the specialty
retail industry because while there are no substitutes for clothing, customers still
have the option of different types of clothing. Bargaining power of buyers in this
industry is moderate due to customers having some power over firms because
their business is needed but successful firms do not depend on one customer to
reach their profits. Bargaining power of suppliers is low in the specialty apparel
industry because there are a large number of suppliers for firms to choose from
based on lowest price and highest quality.
Value Chain Analysis
The retail market is a highly competitive industry. Therefore companies in
this industry need to find their competitive advantage and utilize it to the fullest
extent in order to be successful. There are many objectives in which a firm in
the retail industry should strive to achieve depending on their chosen strategy.
Retailers with more basic products practice a cost leadership strategy by having
a tight cost control system, simpler product designs, and economies of scale and
scope. Whereas the higher end fashion competitors usually follow a more
differentiated strategy including; high investment in their brand image along with
research and development, and exceptional customer service. In this industry it
is a necessity to distinguish yourself from your competitors and gain an upper
hand.
Brand Image
Since the retail industry is mainly undifferentiated, meaning the products
are very similar, investing in a brand image is a very important concept. By
separating your brand from the competitors it gives your company an advantage
and allows them to market easily. Making sure your brands are recognizable to
targeted customers will help firms in this industry gain market share. To become
a recognizable brand firms can focus on advertising and sponsorships. Focusing
on brand image will create customer loyalty ensuring a constant consumer base.
Research and Development
Research and Development is a key factor in the apparel industry. In
order for a company to be successful they have to identify with their audience
and understand consumers’ wants and needs in order to gear their products
towards these specific wants. Understanding current trends for each season is a
hard task to accomplish due to how far in advance these trends must be
forecasted. Sometimes trends have to be forecasted up to a year in advance in
order to allow adequate time for products to complete the supply chain. They
also need to be aware of the spending patterns of potential customers and be
able to predict downturns and how to fix them.
Customer Service
Having superior customer service is a simple way to obtain differentiation.
By creating an enjoyable shopping experience for customers, companies are able
to gain consumer loyalty. When companies create a warm and welcoming
environment for shoppers they have greater customer satisfaction. By making
sure every customer is greeted at the door by employees and helped in finding
exactly what they are looking for, customers will feel comfortable and welcomed
in stores. Customer service is also believed to prevent theft. If the customer
feels welcomed they will be less likely to try and steal from the company.
Tight Cost Control System
Having a tight cost control system in the apparel industry is very
important. Styles change very frequently depending on seasonality and so the
industries must maintain inventory at levels where the clothing is not going to go
out of date and not sale. For example, firms do not want to have a large
inventory of sweaters left from the winter season when the hot summer months
are beginning. Also, having enough inventories during busy shopping seasons
will ensure profits. Keeping a tight control system could prevent losses in the
apparel industry since it’s so competitive. Tight control systems will also help
raise profits. Being efficient manufacturers and being organized will minimize
overhead costs.
Competitive Advantage Analysis
Since Gap Inc. owns a variety of retail stores they compete both through
cost leadership and differentiation. Their higher end stores such as Banana
Republic and Gap follow a more differentiated strategy whereas Old Navy and
Forth & Towne are geared more toward cost leadership. This industry is highly
competitive so it is beneficial for Gap Inc. to focus on cost leadership and
differentiation. By focusing on low cost they are able to compete with a large
amount of competitors in the industry but by also focusing on differentiation Gap
has an advantage that many other firms do not have.
Brand Image
Gap Inc. devotes a lot of time and money to their brand image. For
example, Gap runs special ad campaigns to attract customers. For summer
2006, Banana Republic stores are focusing on advertising for their summer
dresses by displaying large signs of women modeling the dresses in their stores.
Also in the past Gap ran commercials using the slogan “Fall into the Gap” to
promote their products. As a result their brand is a common household name.
They feel that their “ability to develop and evolve their existing brands is a key to
their success” (Gap Inc. 2006 10K). Having a well known brand name such as
Banana Republic gives the company the ability to charge higher prices because
consumers are willing to pay for the name. By having a solid brand name Gap
Inc. is able to market to a variety of market segments with a greater possibility
of gaining devoted customers.
Research and Development
Gap Inc. has to stay on top of economic conditions in their regions. Any
fluctuations in the economy have the ability to affect their operations and
success each season. Therefore the company has to pay close attention to the
spending patterns of their consumers to know at what point in the economy
consumers stop buying. Another big concern for Gap Inc. is trends and
forecasting in the apparel industry. They have to research what consumers want
and be able to forecast that into future seasons since materials have to be
bought well in advance of the final products. Gap must make sure to hire quality
designers even if it means sacrificing cost to some degree. Gap Inc. strives to
“meet its customers’ needs through innovative and inspiring design”
(www.gapinc.com).
Customer Service
All of the Gap Inc. stores take time to specially train their employees in
first-rate customer service. Employees are responsible for knowing all the
products in their respective store in order to act as a personal shopper for
customers. By knowing the merchandise they are able to suggest other items
that are compatible with a customer’s current purchases. They feel that this is a
very strong component of success for their industry. Gap Inc. strives to “make it
easy for people to express their personal style through convenient and engaging
store experience; and by communicating with people in a way that connects to
how they live, work, and play” (www.gapinc.com).
Tight Cost Control
Gap Inc. must maintain tight cost control to be successful in the apparel
industry. One way Gap controls cost is by manufacturing their products overseas
where the labor is much cheaper than in the US. This allows them to drive
product costs down. They also do not hold high volumes of inventory in their
stores so they will not have inventory that is not able to sale. Gap tries to
consolidate their inventory at lower volume stores and ship them to higher
volume stores before the products go on sale. For example, Banana Republic
ships their shoes from smaller (level 0) stores to large (level 4) stores in order to
sale the shoes at the maximum profit possible before they go on sale.
Accounting Analysis
“There is typically a separation between ownership and management in
public corporations. Financial Statements serve as the vehicle through which
owners keep track of their firms’ financial situation. On a periodic basis, firms
typically produce three financial reports: an income statement that describes the
operating performance during a time period, a balance sheet that states the
firm’s assets and how they are financed, and a cash flow statement that
summarizes the cash flow of the firm.” (Business Analysis & Valuation, third
edition) The three financial reports establish a foundation and strong core in
valuing a firm. Overall we will determine if Gap Inc. has a solid foundation using
the accounting analysis within the Generally Accepted Accounting Principles
(GAAP).
Financial Analysts use these reports to analyze how well a company might
be doing or otherwise. There are six steps in analyzing the firm. These six vital
steps are crucial to the key success factors to the accounting analysis. First,
analysts must identify key accounting policies. Accounting policies measures the
risk of a company while it also measures the credibility of a company. Assessing
the degree for potential accounting flexibility is the second step. The potential
accounting flexibility measures the risk of the firm. After obtaining the risk we
then can compare to the industry and their competitors. The third step is to
evaluate actual accounting strategy. With the accounting flexibility managers
can use accounting strategies to their advantage. When it comes to accounting
strategies managers have the ability to hide the true performance of a company
by using various methods to benefit their firm. For example, sometimes
managers use the straight line method for inventory. The next step is to
evaluate the quality of disclosure; qualitative and quantitative. This is where
managers use their financial statements to be aware of the business and also
their competitors. Identifying potential “red flags” is the fifth step in the
accounting analysis. “These indicators suggest that the analyst should examine
certain items more closely or gather more information on them.” (Business
Analysis and Valuation) The final step is undoing the accounting distortions.
When business understate or overstate financial in past year they must correct
them on the next reporting year, so that they won’t mislead.
Key Accounting Policies
Brand Image
In order for Gap Inc. to maintain more appealing brand images, Gap Inc.
must reside in the upper echelon shopping centers or the well maintained
neighborhoods. A company with a higher end brand empirically holds leases in
upper class areas; therefore the majority of companies in this situation are
willing to pay higher prices for rent in order to maintain their brand image.
Keeping a brand image is an important aspect when talking about the specialty
retail industry. When companies pay these higher prices, they are reluctant to
show them on their balance sheet so they adopt operating leases. Gap Inc.’s
operating leases are not shown on the balance sheet. Instead, they are
expensed over time and operate as write offs to your income. With a lower
income, your taxes are lower. If a company were to hold these leases as capital
leases, they would be required to illustrate them on the balance sheet. This
would turn off investors because they are concerned with getting a return.
Research and Development
Research and development is another factor that Gap Inc. focuses in on.
In the specialty retail industry research and development can make or break a
firm. Being able to forecast future trends well in advance is a key to the success
of any apparel industry firm. It’s hard to put a dollar value on the trends that are
predicted by the intangibles. Intangibles may not be clearly defined on any
financial statements. However, intangibles are one of the most important assets
on the balance sheet for companies when the industry is highly competitive like
the specialty retail industry. Gap Inc. states “Our trademarks are valuable
assets, and all employees and business partners should help protect them,”
(Welcome to Gap Inc.) proving that their intangibles are important to their
success. We agree with Gap Inc. in that their trademarks are an asset having
been into the industry for so many years. Gap Inc. is also one of the largest
firms in the retail industry, so to stay on top of the industry they must keep their
trademarks recognizable. The company that has the ideas and know-how will
obtain the largest cash inflows.
Marketing
Marketing is another key aspect that should be focused on with firms in
the retail industry. Advertising can be costly at first but great benefits are
reaped from this because it attracts customers giving higher profits. Gap Inc.
places print ads in newspapers, magazines, outdoor venues. Gap also uses
technological advancements by using the Internet, television, and radio to attract
customers. Marketing is a huge expense for many retail companies. Gap’s
marketing has helped them establish a global company. Successful marketing is
a reason why they are, where they are, today. We concluded that marketing is a
major component to Gap’s success.
Customer Service
Customer Service is another aspect that sets Gap Inc. apart from their
competitors. Training employees to provide them with necessary knowledge is
essential for companies because without knowledgeable employees, customer
service will be lacking. Firms must value their employees and make sure to hire
quality staff. One way companies give back to their employees for their hard
work is through employee benefits. Employee benefit plans include things such
as stock options and defined contribution retirement plans. Employee benefit
plans motivate employees to work hard and strive to achieve the goals of
companies which in the specialty retail industry, good customer service is an
important goal. Gap accounts for their employee benefit plans on the balance
sheet as deferred compensation, other liabilities, and accumulated other
comprehensive earnings.
Tight Cost Control
Tight cost control is very important in the industry. In order to maintain a
higher profit margin on their products sold. Customers can easily find a product
to meet the need provided by companies such as GAP, Inc. Therefore, tight cost
control is a key success factor in the industry. Gap utilizes this by consolidating
their inventory rather than over producing. This eliminates the waste and cost of
excess inventory. Gap puts products in stores according to there inventory
turnover rate. The higher volume stores receive the most product and the lower
volume stores receive just enough inventory to satisfy their customers’ need. If
a product does not sell for full price, prior to placing the item on clearance, the
company ships the unsold product to higher volume stores in an attempt to sell
the product for the full desired margin. This is important because it is one way
the company tries to eliminate the cost of waste.
In addition to cutting costs within operations, on the financial statements
the companies accounting policies average out the costs of inventory over time.
Also, their inventory on the balance sheet is recorded at a lesser amount
because it takes into account inflation costs in the industry. GAP, Inc. values
their inventory “at the lower of cost or market and record a reserve when future
estimated selling price is less than cost.” (GAP Inc. 10-K). This backs up the key
success factor because their operations method, as described above, and their
accounting policies attempt to level out cost over time rather than take short
cuts and achieve a higher benefit this year and feeling the consequences next
year while maintaining their margin on all of their products.
Gap Inc.’s five key accounting policies in brand image, research and
development, marketing, customer service, and tight cost control play a large
role into Gap Inc.’s valuation. These key success factors go hand and hand with
Gap’s principles.
Accounting Flexibility
The FASB allows firms to be flexible in their accounting policies. Being
flexible is an important aspect to a firm because it allows them to manipulate the
accounting system in way that is most beneficial for them. The purpose of the
accounting flexibility is to measure the risk and success factors of an industry.
Gap Inc.’s flexibility accounting in the specialty retail industry allows managers to
market the brand image on a different level. Flexibility can as well be a downfall
if Gap does not stay consistent in their financial reporting.
Gap Inc.’s flexibility is closely related to the accounting principles. Gap
relies on brand image, customer service, research and development, marketing
and tight cost control. Brand image is a success factor for Gap Inc. because with
the right image new customers will become reoccurring customers. Loyal
customers recognize the quality of the product with Gap’s brand image.
Customer service starts with Gap’s employees. Gap Inc. spends millions of
dollars to their training program in order to retain knowledgeable employees.
“To remain competitive in the apparel retail industry we must attract, develop
and retain skilled employees, including executives. Competition for such
personnel is intense. Our success is dependent to a significant degree on the
continued contributions of key employees.” (2006 Gap Inc. 10-K) Pensions help
retain employees as well allowing them to plan for the future with a retirement
plan in a 401K. Research and development is also a large expense of the
accounting process in retail industry since it is highly competitive. Tight cost
control is difficult at first, but with training employees Gap Inc. is saving money
in the long run.
In conclusion to the accounting flexibility Gap maintains a flexible
accounting strategy. In order for Gap to stay flexible, they must abide by the
guidelines by the GAAP and the FASB.
The graph below represents the total inventory from 2003-2007.
Keeping flexible accounting strategies is a way to maintain the inventory of the
company. This allows firms to make decisions to what methods to use for
inventory as well as goodwill.
Evaluate Actual Accounting Strategy Evaluating a company’s accounting policy can tell you a lot about that
company. The two different strategies are conservative accounting and
aggressive accounting. According to the textbook Business Analysis & Valuation,
“the logic of using conservative accounting is justified with expensing of research
and development, advertising and the rapid write-down of intangible assets”
2003 2004 2005 2006 2007
Total Inventory
2,048
1,7041,814
1,6961,796
0
500
1,000
1,500
2,000
2,500
Year
Millions
(Business Analysis and Evaluations 3rd edition 3-12). On the flip side of
conservative accounting is aggressive accounting. Aggressive accounting, by
definition, is “the practice of inappropriately misconstruing income statements for
the purpose of pleasing investors and inflating stock prices”
(TheFreeDictionary.com). With keeping investors happy and raising stock prices
it has the appearance to benefit the company. Higher stock prices show that the
companies are doing well and investors are more willing to invest into the
company. With our research with Gap Inc. we have determined that they use
aggressive accounting some of the times, but overall they are moderate.
Looking at Gap Inc.’s 10-K we believe Gap uses aggressive accounting
because of their use of operating leases. Operating leases reduce the liabilities
shown on the balance sheet because Gap does not capitalize their leases. The
use of the gift cards also shows Gap Inc.’s aggressive accounting. They report
gift cards and gift certificates as a liability and then are recorded as net sales
when they are received. Managers are more likely to use these accounting
practices for the incentives. However, we found that Gap Inc. is also
conservative by not disclosing enough information in their 10-K by not
overstating their liabilities. Conservative accounting can be just as misleading as
aggressive accounting in its unbiased judgment.
Overall Gap Inc. is moderate when it comes down to its accounting
policies. They are aggressive at times at some of the things they do and
conservative with the others. Gap is going to both the accounting policies
because it is best for their company. Gap is aggressive in advertising, an
example of this is in Old Navy. In conclusion we believe that Gap Inc.’s
accounting strategies are another factor in the evaluating process.
Quality of Disclosure
Qualitative Measures
In an overview of the financial statements, the company looked as though
they were giving sufficient detail. There was a lot of information to sift through,
but a lot of the information was repeated or definitions of GAAP. To look into
the business and see how transparent the company was, we had to go to outside
resources about the company. While we understand the account policies and
are well informed on how the company reports issues, the 10-K’s footnotes are
not the best resource to use when dealing with management issues. The
quarterlies are the place to look. The quality of their segment reporting was
great compared to their annual 10-K. This is important because it is easier to
find details about each entity within the corporation and understand
management decision better. In the 10-K, Gap tells the investors and readers
that they switched their methods of reporting inventory and cost of goods sold
from FIFO to WAC, but they never tell us why. The company has two
paragraphs in the 10-K where it discloses their methods used to account for their
assets explaining the two different methods; however, they failed to inform us
on why they changed methods.
In the letter to the shareholders of 2006, Gap tried to better explain
things but blames it on the customer response not being as high as they
anticipated. They fluffed the letter with words such as it “was a difficult year”
and “well aware of what this company is capable of.” (Letter to the Shareholders
2006). They tell us they increased their expenses but do not tell us why that was
necessary to raise customer response. They declined to tell us what they
planned to do to correct the fall. They talk about the potential of the company in
coming years but give us no ideas why next year is meant to be different. This
is important because the amount of information on how to correct mishaps was
inadequate. All of the shareholders knew that this was a bad year; they saw it in
the fall of their stock prices. But the letter seems limiting to the situation. There
is a lot more the company could explain.
Another instance of bad news that was not very well disclosed is
concerning their spin off line of Forthe & Towne. In this situation, Forthe &
Towne was not meeting their ideas of profitability. A few years after opening the
line, a news article was released announcing the closure of all stores by June of
2007. The stores have all been closed and there is still no information in the
shareholders note about this entity. Gap, Inc. has kept quiet about why this
store closed. The most information we have gathered says it was not meeting
required returns. The timeliness is not great with Gap, Inc on their disclosures of
bad news. Whereas, when they are telling the shareholders about good news,
such as the new hire of a high end fashion designer the news came out in the
next Wall Street Journal being printed. They seem to want to get the good news
out while hiding the bad news until the last possible moment. When they do
disclose the bad news it isn’t very detailed. They try and disclose too much good
and not enough bad. This is important when analyzing the company’s
transparency and the mix of disclosing news.
The audit report has good qualities and bad qualities. We found that
Deloitte & Touche, LLP. has audited the company for the past five years.
Deloitte has stated that the financial statements fairly present the company.
When you have a firm such as GAP that has the same audit company audit their
company every year, you run into some problems. Is the auditor comfortable
and just signing off on the report? Do they overlook material misstatements? On
the other hand having the same auditor for the past five years proves that the
audit firm is confident enough to know that Gap is not going to be a risk to
them. It also is good to have to same auditor because Gap would not continue
to use the same auditor year to year if they were receiving a bad audit report.
After evaluating the different methods Gap, Inc. uses within GAAP’s
flexibility we felt it was better illustrated in the different sections of this
valuation. Overall, Gap is moderately aggressive. On issues such as expense
methods for inventory, they were relatively conservative with cause’s net income
to be moderately lower than if they use their competitors’ methods. On other
issues the company is aggressive which makes it difficult to fairly compare the
company to others in the industry.
Quantitative Measures
Quantitative measures rely on the financial data when analyzing a firm.
Quantitative analysis is dealing with nothing but numbers, which in turn are
facts. Numbers do not lie when it comes down to it, which is why working with
numbers is easier. Quantitative data compares one firm’s data to another or its
competitors. The quality of disclosure with quantitative measures assures the
quality of the firms’ accounting process. The quality of the disclosure talks about
the two measures, qualitative and quantitative. We have already discussed the
qualitative measure which deals with analyzing the company through words and
not figures.
We will now use some ratios Gap uses to determine how well the sales
are supported by the cash flow. The ratios consist of Net Sales/Inventory,
CFFO/OI, Asset Turnover, and Total Accruals/Sales. Some of the other ratios are
not applicable to Gap Inc. because they do not show their accounts receivable in
their financials. To be able to analyze the some of the different ratios Gap Inc.
must show their accounts receivable in their statements.
Net Sales/ Inventory
Net Sales/Inventory
0
2
4
6
8
10
12
14
16
2002 2003 2004 2005 2006 2007Year
Ratio
s
Gap Inc.AbercrombieAmerican Eagle
Net Sales/ Inventory 2007 2006 2005 2004 2003 2002
Gap Inc. 8.88 9.45 8.97 9.3 7.06 7.82
Abercrombie 9.15 13.18 11.84 11.83 14.65
American Eagle 10.6 11.02 13.7 12.6 11.73 15.06
Net Sales/ Inventory is an important ratio because it determines the quickness of
moving out your overall inventory. Keeping track of inventory can help a
business manage its assets and help keep the accounting process in line.
Getting inventory in and out is also key, the less time you keep the inventory the
more profit is to gain because it will be in the hands of the buyers. Overall this
graph shows the three retail competitors ratio of net sales/inventory. American
Eagle and Abercrombie started off well in 2002 and 2003 but have been on the
decline ever since. Gap Inc. has consistently moved its inventory and because of
that their ratios have been steadily increasing.
CFFO/OI
Cash Flows from Operations divided by Operating Income shows how
much income Gap and its competitors have from cash sales. If the number is
lower than one, then the income is not supported by cash. This is important
because the lower the number is the more sales that are supported by
receivables. Receivables are not all going to be collected. Sometimes you have
people who buy things on credit and then disappear. This money is written off
as bad debt expense and lowers your income. The higher number this is the
cash you see in transactions. It helps investors choose whether or not to invest,
or how much to invest. For this graph the three companies showed the same
pattern. When the ratio for these companies is declining, their income is not
supported by cash. For the most part Gap had a decline every year except one
over the past six years. American Eagle was the only company to have the ratio
increase from year three to four. Overall, the companies CFFO/OI are very
similar to one another. Even though one company’s ratio might be increasing
they in general are relatively the same.
CFFO/OI
CFFO/OI
00.20.40.60.8
11.21.41.61.8
2
1 2 3 4 5 6
Years
Rat
io
Gap Inc.AbercrombieAmerican Eagle
Net Sales/Cash from Sales Ratio
Net Sales/Cash from Sales
0.99
0.995
1
1.005
1.01
1.015
1.02
1.025
2003 2004 2005 2006 2007
Year
Ratio Abercrombie
Gap Inc.
We compared Gap to Abercrombie in Net Sales/Cash from Sales because
they are Gap Inc.’s main competitor. Although there are only two firms being
compared they both show very similar traits. Gap will continue to stay at a
constant because they do not show their accounts receivable. This ratio
analyzes the liquidity of turning your current assets to cash.
Asset Turnover A key ratio in which companies use to measure their expenses is the asset
turnover ratio. This ratio is preformed by dividing the sales by the total assets of
the business. Companies desire a higher ratio because it means that their assets
are bringing in enough revenue; therefore if this ratio declines over time it raises
a concern. As you can see in the chart below Gap is successful in that their
ratios are steadily increasing for the most part where as American Eagle’s are
declining. Due to their rising numbers a red flag is not demonstrated by this
ratio because when you have an asset turnover that is greater than one, it
means that you making more than you lose. However a red flag is a possibility if
a firm chooses to leave out the data out of their financial statements, such as the
balance sheet.
Asset Turnover
0
0.5
1
1.5
2
2.5
2002 2003 2004 2005 2006 2007
Year
Rat
io
Gap Inc.
Abercrombie
American Eagle
Total Accruals/ Sales
This expense ratio takes the total accruals which is the net income minus the
cash flow from operations, and divides it by total sales per company. The total
accruals come out as a negative amount because cash flows from operations are
always larger than net income; therefore the said ratio is also negative. As a
result this ratio can be used to see if the company is possibly trying to overstate
their income. As seen in the chart below Gap and its competitors have similar
progressions in this particular ratio. The spikes downward could be an indication
of suspicious recording, however since all of the companies have this at the
same time it is most likely not a cause for concern.
Total Accruals/ Sales
-0.3
-0.25
-0.2
-0.15
-0.1
-0.05
02007 2006 2005 2004 2003 2002
Year
Rat
io
Gap Inc.American EagleAbercrombie
The overall purpose of the ratio analysis was to compare Gap Inc. with its
competitor, American Eagle and Abercrombie, in the specialty retail industry.
After computing these ratios we can conclude that Gap is a better company than
its competitors at this stage. One reason for this is that its one of the leading
retailers at this time.
Identify Potential “Red Flags”
In the accounting analysis, “red flags” are indicators that lead to
questionable accounting for a firm or industry. “Red flags” could be frequent
changes in a company’s accounting, and unexplained transactions. They could
also be sudden increases in profits or decreases, as well.
Inventory can be a good thing to look at as analysts, especially in the
retail industry. When Gap has a large amount of unexplained inventory, it
means that they are expecting record sales. If they do not move the inventory
the asset turnover will fall, which will drastically affect everything they do. With
lots of sales it means that the company usually is making adequate profits.
When inventory is low, this usually means that companies are not so prosperous
or that demand has fallen.
According to the net sales and inventory ratios for Gap Inc. and
Abercrombie, their numbers show potential red flags: (Table below)
Net Sales/ Inventory
Year Gap Inc Abercrombie
2006 9.45 9.15
2005 8.97 13.18
2004 9.30 11.84
2003 7.06 11.83
2002 7.82 14.65
As you can see Gap Inc. ratios have been increasing over time and
Abercrombie’s ratios have been decreasing. These could lead to potential
concerns with Abercrombie. Gap Inc. is one of the leading industries in the
apparel retail industry, though competition is really increasing with other
competitors and has forced Gap to decrease in sales recently, Gap stands strong
because of its size.
Another potential red flag is Gap Inc. operating leases. Gap Inc.
apparently has operating leases that don’t expire until 2033 however most of
their stores are only for five year leases. This is a red flag because having their
leases forecasted out so long gives them opportunity to hide their liabilities.
Unearned revenue such as gift card could be a potential “red flag” too,
but since Gap Inc. 10-K’s lets the public know how they are recorded, then they
are now considered red flags. Gap’s footnotes claim, (Gap Inc.’s 2007 10 K)
“Upon the purchase of a gift card or issuance of a gift certificate, a liability
is established for the cash value of the gift card or gift certificate. The
liability is relieved and income is recorded as net sales upon redemption. Over
time, some portion of the gift cards issued is not redeemed. This amount is
recorded as other income, which is a component of operating expenses.”
Undo Accounting Distortions
According to the red flags that we found and Gap Inc.’s 10-K they did not
disclose enough information for us to undo any of the red flags. The one area
that we were concerned about was their operating leases. Gap does not disclose
enough information on their operating leases to undo any of their accounting
distortions. There was insufficient evidence to support and back up any of the
undoing to the accounting distortions.
Financial Analysis
The growth and profitability is the key success factor for any company.
There are many ratios that analysts use to see how well a company is doing.
They also use these ratios to compare the company they are analyzing with
other companies in the same industry. There are liquidity ratios that measure
the ability to convert assets into cash as quickly as possible, and there are
profitability ratios that measure how profitable a company is. In the retail
business or any business, if there is no profit the success for a company is very
slim. The firm’s capital structure is simply determined by debt and equity; the
amount of debt used to finance the firms assets. Analysts use all of these ratios
to compute future forecasts for the industry and/or company they are analyzing.
They must use these ratios to estimate accurate and realistic numbers for future
years. These forecasts allow the public and investors to get a true
understanding of how well the company is performing.
Ratio analysis takes the ratios to help value a firm. This analysis
compares a company with its competitors to see if there is any trend or
consistency. Sometimes there might be a year that indicates a problem or
something significant happened. For example, on September 11, 2001, the
terrorist attacks at the twin towers had a great impact on many firms. The 2001
year would be an outlier to the rest of the years, because in this year all the
numbers were very low compared to other years due to September 11, 2001.
Analysts use past and present financial statements to be able to value the firm
using the liquidity ratios, profitability ratios, and capital structure ratios. Analysts
will take outliers out of their forecasts to maintain the most accurate forecasts
possible.
Liquidity Analysis
Liquidity analysis includes ratios that measure the ability to convert assets
into cash. The current ratio measures whether or not the company will be able
to pay its liabilities. This shows a company’s leverage to pay its debt. The quick
asset ratio is another means to measure the short term liquidity of a company.
The accounts receivable turnover is the ability to collect the accounts receivable
to free up cash. The more money you free up the more money you have in
hand to invest back into the company or for sales growth. The day’s supply of
receivables is the time period it takes to collect payment from customers for
sales. Inventory turnover measures how many times the product or inventory
has been sold or replaced. The more times it turns then the more efficient the
company looks. Profit is earned every turn it takes from selling its inventory;
therefore the higher the number the better. The day’s supply of inventory ratio
is simply the average amount of days it takes a company to sell their inventory.
Finally, the working capital turnover ratio is, “a measurement comparing the
depletion of working capital with the generation of sales over a given period.
This is a good indicator of company growth and liquidity. The ratio is derived by
taking net sales and dividing by average working capital.” (www.financial-
dictionary.thefreedictionary.com) All of these ratios are part of the liquidity
analysis.
Current Ratio
The current ratio is highly used by investors to measure the company’s
liquidity. It is computed as current assets divided by current liabilities. The
higher the number the better the company will be able to pay its liabilities, or
debt. In the specialty retail industry, it is very competitive and the ratio is
expected to be higher than one in order to stay in business. If they fall below
one, investor’s will think something could be going wrong in the business. The
current ratio should be between one and two. As you can see on the graph, Gap
Inc. keeps on going up every year. Gap is such a huge company that keeps on
expanding; it seems like they are pulling away from their competitors. While
Gap’s competitors keep fluctuating, they are in accordance with the industry and
have not fallen under one, which is good. They too are able to pay their debt
and show some leverage.
Current Ratio
00.5
11.5
22.5
33.5
44.5
5
2002 2003 2004 2005 2006
Years
Gap Inc
Abercrombie
American Eagle
Industry Average
Quick Asset Ratio
The quick asset ratio is another ratio that analysts use to measure the
immediate short term liquidity of a company. This ratio shows how much assets
are available instantly. Quick asset ratio is calculated by cash, marketable
securities, and net receivable divided by current liabilities. At times this ratio
acts as a test for companies to see how liquid they are. Gap Inc. is steady and
consistent throughout. Gap is rising when American Eagle has dropped
significantly from 2004 to 2006. Abercrombie seems to stay a little under Gap.
Quick Asset Ratio
0
0.5
1
1.5
2
2.5
3
2002 2003 2004 2005 2006
Years
Gap IncAbercrombieAmerican EagleIndustry Average
Accounts Receivable Turnover
The accounts receivable turnover and the day’s supply of receivables are
not applicable to Gap Inc. since they do not show their accounts receivables in
their financial statements. These ratios are hard to compare with their
competitors for this reason. The receivables turnover simply emphasizes how
long it takes them to convert their receivables into cash. If companies collect
their receivables slower then they soak up all their cash, they are losing the
opportunity to invest in the company or to support additional sales growth. So
mainly in the retail industry if the days supply of receivables keeps going up it
means that it is taking longer to collect receivables and could indicate a problem.
Unfortunately, Gap does not show any records of account receivable to be able
to compute the ratio in order to analyze how it’s doing against the industry.
Inventory Turnover
“Managing inventory is a juggling act. Excessive stocks can place a heavy
burden on the cash resources of a business. Insufficient stocks can result in lost
sales, delays for customers etc. The key is to know how quickly your overall
stock is moving or, put another way, how long each item of stock sit on shelves
before being sold. Obviously, average stock-holding periods will be influenced by
the nature of the business.” (www.planware.org/workingcapita.com)
Inventory turnover measures the liquidity of the inventory. As you
can see in the graph, Gap has stayed between 4 and 6 from 2002 to 2006
where Abercrombie has decreased significantly from 7 to about 2.5.
American Eagle has dropped some from 2002 at 7.5 to 5.5 in 2006.
Inventory turnover is an average of how many times the inventory is sold in
a time period.
Inventory Turnover
0123456789
2002 2003 2004 2005 2006
Years
Gap IncAbercrombieAmerican EagleIndustry Average
Days Supply of Inventory
The day’s supply of inventory ratio is simply the average days to sell
their inventory. This measures how many days on average a company has
inventory on hand or stock. There are different levels for every industry. In
the retail industry, the level has been approximately between 45 and 100.
Abercrombie though keeps their inventory on hand very high. They have been
increasing tremendous. Usually the companies that keep their inventory at
lower levels and are still able to keep up with satisfying their customers are the
ones that are going to be the most successful. So far Gap and American Eagle
seem to stay very close to each other in this aspect.
Days Supply of Inventory
0.0020.0040.0060.0080.00
100.00120.00140.00160.00
2002 2003 2004 2005 2006
Years
Day
s
Gap IncAbercrombieAmerican EagleIndustry Average
Working Capital Turnover
Working capital is a firm’s current assets less current liabilities. Therefore,
working capital turnover is a firm’s ability to turn its working capital into sales.
The higher the working capital the better and more liquid a company is. In
2002, Gap’s working capital turnover was lower than its competitors. Through
the past 5 years, Gap has steadily increased its working capital turnover. They
started in 2002 with a working capital turnover of 3.44 but ended 2006 with a
ratio of 5.78. American Eagle’s working capital turnover ratio has slowly
decreased from 2002 to 2006 probably due to the fact that their current liabilities
have steadily increased since 2002. Since Abercrombie had a very high 2004
working capital turnover, the industry average was well above Gap in 2004. In
2006 however, Gap was able to outdo their competitors by more efficiently using
its working capital to fund its operations.
Working Capital Turnover
0.001.002.003.004.005.006.007.008.009.00
2002 2003 2004 2005 2006
Gap, Inc.AbercrombieAmerican EagleIndustry Average
Cash to cash cycle
Since Gap does not have any accounts receivable the receivables turnover
does not apply to them. Without a receivables turnover they are not able to
calculate days sales uncollected. Since the cash to cash cycle is the days sales
uncollected plus the days supply of inventory it can not be computed for Gap.
Therefore in reality there cash to cash cycle would just be the amount of time it
takes to turn their inventory.
The liquidity ratios determine how liquid a firm is for a specific time
period. The current ratio and quick asset ratio provide evidence that Gap is able
to pay off debt in comparison with its competitors. Inventory turnover and days
supply of inventory ratios for Gap remained relatively unchanged from years
2002-2006. They were sometimes better and sometimes worse than American
Eagle and Abercrombie with their ability to sell inventories efficiently.
Profitability Analysis
“Any successful business owner is constantly evaluating the performance
of his or her company, comparing it with the company's historical figures, with its
industry competitors, and even with successful businesses from other industries.
To complete a thorough examination of your company's effectiveness, however,
you need to look at more than just easily attainable numbers like sales, profits,
and total assets. You must be able to read between the lines of your financial
statements and make the seemingly inconsequential numbers accessible and
comprehensible.”(http://www.vainteractive.com/inbusiness/editorial/finance/ibt/r
atio_analysis.html)
The profitability analysis is the ratios that help analysts conclude the
efficiency of the company’s sales, profits, and total assets. These ratios show
how prosperous a company is and are also used to estimate forecasts for
financials for future use. The gross profit margin, operating profit margin, and
net profit margin are ratios that measure the operating efficiency for a company,
while the asset turnover, return on assets, and return on equity measure the
profitability for a firm. All these ratios are used to compare with competitors of
the same industry to see how well they measure up to each other.
Gross Profit Margin
Gross profit margin is a coverage ratio in which allows firms to compare
their gross profit to their overall sales. Gross profit is found by subtracting cost
of goods sold from sales. In order to find the margin you have to divide this
number by the total sales. The gross profit margin shows whether or not the
company is bringing in enough revenue to cover the cost directly related to
sales. Companies strive to have a greater gross profit margin because it means
they are achieving a higher level of operating efficiency. While Gap Inc. has a
decent gross profit margin it happens to be the lowest out of its main
competitors, as depicted in the graph below. However, they do seem to have a
trend over the past five years; therefore investors should expect around the
same margin in future years.
Gross Profit Margin
0.00%10.00%20.00%30.00%40.00%50.00%60.00%70.00%
2002 2003 2004 2005 2006
Year
Gap, Inc.
Abercrombie
American Eagle
Average
Operating Profit Margin
The operating profit margin is another ratio used to measure the
efficiency of operations. This particular calculation divides the operating income,
which is the gross profit minus all operating expenses, by total sales. The
majority of operating expenses are fixed costs, therefore this ratio shows how
well sales cover selling and fixed costs. This is another ratio in which companies
what to strive for a higher percentage. Companies with a high operating profit
margin usually have low fixed costs and or higher gross profits than their
competitors. Unfortunately Gap’s operating profit margin has been declining
over the past couple of years. This is due in part to their slightly decreasing
gross profit combined with their increasing operating expenses.
Operating Profit Margin
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
2002 2003 2004 2005 2006
Year
Gap, Inc.
Abercrombie
American Eagle
Average
Net Profit Margin
Yet another measure of operating efficiency, the net profit margin is
calculated by dividing the net income by the total sales. This ratio allows firms
to see how much profit they are earning for each dollar of revenue received. As
you can see from the below graph, the trends in the net profit margin are very
similar to those of the operating profit margin. The higher a net profit margin
based on a firm’s competitors the better. However, “In some cases, lower profit
margins represent a pricing strategy,” which could explain Gap’s overall lower
net profit margin. (www.beginnersinvest.about.com)
Net Profit Margin
0.00%2.00%4.00%6.00%8.00%
10.00%12.00%14.00%16.00%
2002 2003 2004 2005 2006
Year
Gap, Inc.AbercrombieAmerican EagleAverage
Asset Turnover
Asset turnover is an important profitability measure. It allows firms to see
how much sales are being generated by each asset. This ratio is calculated by
dividing the total sales by the average assets over a given time period. The
greater the turnover rate the more money each asset is producing for the
company. As illustrated in the below graph, these firms have very similar asset
turnover ratios due to the competitiveness of the retail industry. However,
Abercrombie and American Eagle have pretty much stabilized their asset
turnover where as Gap’s continues to gradually increase. This is beneficial for
Gap because it shows that they are receiving more profit from each of their
assets produced than their competitors.
Asset Turnover
00.10.20.30.40.50.60.70.80.9
1
2002 2003 2004 2005 2006
Year
Gap, Inc.
Abercrombie
American Eagle
Average
Return on Assets(ROA)
Return on assets ratio shows a firm’s ability to use its assets to generate
net income. By taking net income from a current year and dividing it by ending
total assets of the previous year, ROA is computed. “The ROA figure gives
investors an idea of how effectively the company is converting the money it
has to invest into net income. The higher the ROA number, the better, because
the company is earning more money on less investment.”
(www.investopedia.com) Gap is well below its competitors and the industry
average in using their assets to generate net income. In 2002, Gap’s ROA ratio
was 4.82% and in 2005 their ROA peaked at 11.08% and then dropped again in
2006 to 8.82%. Abercrombie and American Eagle ROA’s fluctuated throughout
the past 5 years but their ROA ratios are still well above Gap’s. Gap is not as
efficient as its competitors at using it’s assets to generate income.
Return on Assets
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
2002 2003 2004 2005 2006
Gap, Inc.AbercrombieAmerican EagleIndustry Average
Return on Equity(ROE)
Return on Equity shows how much net income a firm can generate from
the money shareholders give them. Abercrombie leads the industry with their
ROE ratios. Gap’s return on equity ratio is below the industry average every year
except in 2003. Gap peaked in 2004 with an ROE ratio of 24.74% but then that
ratio fell the next two years. In 2006 Gap’s ROE ratio was only 14.34%. In
2002 and 2006 Gap had significantly lower net income amounts which made
their ROE ratios lowest in these two years considering the past five year’s ratios.
Gap is the lowest in the industry when using shareholder’s investments to
generate income for the firm.
Return on Equity
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
2002 2003 2004 2005 2006
Gap, Inc.AbercrombieAmerican EagleIndustry Average
The profitability analysis ratios show how efficient companies are relative
to things such as sales, profits, and total assets. Gap’s gross profit margin over
the past five years is lower than the industry average which is not a good thing
since it is better to have a high gross profit margin. Gap shows lower
profitability than competitors in the industry with their operating profit margin
and net profit margin ratios. Gap’s asset turnover ratio is higher than the
industry average for a majority of the past five years providing evidence that
Gap’s assets generate high sales. Return on assets and return on equity ratios
for Gap fall short of their competition showing how they are not able to use their
assets and money from shareholders to generate income as well as their
competitors.
Capital Structure Analysis
The capital structure premise of a firm is to acquire assets. There are
three different capital structure ratios: Debt to Equity, Times Interest Earned
and Debt Service Margin. Debt to Equity Ratio is the total liabilities divided by
the total owners’ equity. This ratio determines whether or not the company has
a profitable ratio or is in debt. The times interest earned ratio is operating
income divided by interest expense. This ratio shows how much a company is
paying in interest. The last ratio Debt Service Margin is calculated by cash
provided by operations and divided by the installments due on long-term debt,
this measures if the firm can cover the amount of their liabilities. There are two
concerns with the Capital Structure. One concern being is the debt that goes
along with the owners’ equity. The second is whether the firm can handle the
principle and the interest that is tied to it.
Debt to Equity Ratio
The Debt to Equity Ratio shows how the firm operates and gives facts on
their capital structure. This ratio looks at a company’s liabilities and its owner’s
equity. Gap’s ratio for 2006 was 1.16 which was lower in comparison to the year
before. However was substantially higher than 2002 and 2003. Gap will need to
lower their debt to equity ratio to become more profitable and compete with its
competitors. A firm strives for a lower debt/equity ratio, less financed through
debt the less interest they have to pay. Overall Gap Inc.’s Debt to Equity ratio is
lacking in comparison to its competitors.
Debt to Equity
0
0.2
0.4
0.6
0.8
1
1.2
1.4
2002 2003 2004 2005 2006
Year
Average
Gap
Abercrombie
American Eagle
Times Interest Earned
“The times interest earned ratio indicates the extent of which earnings
are available to meet interest payments” (Bizwiz.com). The times interest
earned ratio shows how much Gap can cover its interest charges. “A lower
times interest earned ratio means less earnings are available to meet interest
payments and that the business is more vulnerable to increases in interest
rates” (Bizwiz.com). Gap Inc.’s times interest earned ratio was quite different
to its competitors. Abercrombie average over the last five years was 73.53
while Gap Inc.’s was .35. The difference is that Gap is struggling to cover their
interest while Abercrombie is not.
2002 2003 2004 2005 2006
Gap 0.28 0.43 0.44 0.41 0.21
Abercrombie 82.89 89.44 66.62 81.32 47.36
Times Interest Ratio
0
20
40
60
80
100
2002 2003 2004 2005 2006
Year
AbercrombieGap
Debt Service Margin
Debt Service Margin ratio is cash provided by operations that is divided by
the installments due on long-term debt. This ratio was created to measure the
annual payments of the long term liabilities, being the previous year. The
average debt service margin for Gap Inc. was 1.39. Abercrombie averaged 5.79
while American Eagle averaged 4.15. A higher number is good for the firm
because it allows them payoff their liabilities. Gap Inc. is not looking good in this
industry because they are forced to be tighter on their assets.
Debt Service Margin
012345678
2002 2003 2004 2005 2006
Year
AverageGapAbercrombieAmerican Eagle
The capital structure analysis consists of the debt to equity, times interest
earned, and debt service margin ratios. Gap’s debt to equity ratio is above the
competitors for all past five years but their times interest earned ratio is well
below competitors in their industry. Debt service margin for gap was well below
the industry average for all five years represented on the graph.
Internal and Sustainable Growth Rates
“The highest level of growth achievable without obtaining outside
financing” is called the internal growth rate. This definition is shown on
investopedia.com. The internal growth rate (IGR) is significant in determining
the ability for a firm to remain profitable in the future. It is measure by using
the return on assets equation and factoring in the dividend payout ratio. The
dividend payout ratio is used because it measures the companies guiding
principle for dividends. A dividend is the process a company uses to put excess
cash flows from the business back into the investors hands.
The Sustainable Growth Rate takes the IGR and adds the current
outsourced debt into the equation. The sustainable growth rate, or SGR, is the
“maximum growth rate that a firm can sustain without having to increase
financial leverage.”(Investopedia.com). This means that the SGR keeps the bar
for how much a company can grow. When a company begins financing projects,
they are utilizing their IGR which is very productive. At the point that they
exceed their IGR, they use their SGR. This is more risky and screws with the
ratios investors care about. They are exceeding their spending and investors
should be concerned about projects being undertaken. After they exceed the
SGR on their spending limit, they are opening new lines of credit and stretching
their financial worth. While it is good for a company to have a positive IGR and
SGR, it is not good for their maximums to be extremely high. That is a signal
that the company is not utilizing their resources well. Now, let’s look at the
specialty apparel industry in terms of these growth rates.
Internal Growth Rate
0
0.05
0.1
0.15
0.2
0.25
0.3
0.35
2002 2003 2004 2005 2006
Year
Gap, Inc.American EagleAbercrombieAverage
When analyzing this chart, understand that Gap pays out more dividends
per year on average than American Eagle and Abercrombie. This hinders the
companies growth rates since the major factor in both growth rates is the
dividend payout percentage. While Gap has a lower SGR, they put more money
back into the hands of investors with confidence they will reinvest in their worth,
or value. It will benefit the company more. When looking at net sales of each
company and comparing them, you realize that Gap has insanely high sales
comparatively. Gap is more places then these two companies. They have more
locations and product lines. While they have a lower IGR, they are still holding
on to their profitability. Do notice the drop in the IGR however. We as a group
feel this is a major valuation issue. If the IGR continues to drop, the company
could be in trouble. Whereas American Eagle and the industry as a whole’s IGR
is well above Gap’s and headed upward. That is the reason this chart is a large
eye sore to the company.
Sustainable Growth Rate
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
2002 2003 2004 2005 2006
Year
Gap, Inc.American EagleAbercrombieAverage
The Sustainable Growth Rate is very important. Again you notice the
decline in rates for Gap; however the decline is also prominent for Gap’s
competitors as the industry average is declining. For Gap specifically, their
return on equity had a running average lower than both the named competitors
and remembering from the IGR a higher dividend payout ratio. This keeps their
SGR down below average. Having a lower percentage in the return on equity is
not a good thing because that shows how good a company is with the investor’s
money. With a low SGR, the company will not be able to grow as fast as its
competitors which may hinder it in the long run, because they have a harder
time turning the investor’s money around.
Other ratios
Property, Plant, and equipment turnover Property, plant, and equipment (PP&E) turnover is an important ratio considering
that PP&E is the most important long term asset to a firm. This ratio is
sometimes called the fixed asset turnover it takes sales and divides it by net
PP&E. It reveals how effectively a company invests in PP&E; therefore, the
higher the ratio the better in most cases. Sometimes when a company has a
large investment in fixed assets they will not see a great return right away. For
this reason it is recommended to keep track of this turnover because it should
increase if it was a good investment. It also alludes to a firm’s cash investments
because the change in PP&E shows how much a company is reinvesting in itself.
Depending on the nature of a firm, different companies will have a variety of
PP&E turnovers. For example, manufacturing firms will have a smaller PP&E ratio
than other firms because the majority of their assets are in land and machines.
Gap has a relatively average PP&E turnover compared to the rest of the retail
industry. Therefore they seem to be holding their fixed assets relatively
constant.
PP&E Turnover
0.001.002.003.004.005.006.007.008.00
2002 2003 2004 2005 2006
Year
AverageGapAbercrombieAmerican Eagle
Operating cash flow ratio
The operating cash flow ratio is calculated by dividing cash flow from operations
by current liabilities. The operating cash flow ratio indicates how well incoming
cash covers current liabilities. By using cash flow from operations it gives a
better estimate of how quickly the firm can become liquid in the short run to pay
off liabilities. As seen in the below graph Gap has the lowest performance for
this ratio.
Operating Cash Flow
0
0.5
1
1.5
2
1 2 3 4 5
Year
GapAbercrombieAmerican EagleAverage
Forecasting Analysis
Income Statement
The income statement was the first financial statement forecasted. We
used several steps in determining the best rate to forecast net sales. First, we
took the average of our IGR which was 10.05%. According to
www.finance.yahoo.com, analyst predicted over the next five years for Gap to
grow at a 12% rate. This seems ridiculous when you look at the IGR we have
calculated for Gap. The rate has dropped 50 percent from 10.67 to 5.93 in the
last year. Yahoo Finance also predicted the industry for the next five years to
grow at a rate of 13.88%. Gap has lagged in the industry for years and Gap
would not be able to achieve this predicted growth rate.
After considering the average rate that we computed for IGR we do not
think it is possible for Gap to grow at 12% in the future. By taking the average
growth rate of the analyst’s prediction for Gap from yahoo.com and our own
computation of average IGR for Gap we came up with 11.025%. We still
thought this number was slightly higher than Gap would grow in the future. To
offset this imbalance, we took 14 primary ratios we have computed to analyze
Gap’s financials and picked out the ones which used net sales as a variable. Of
these we computed the changes in growth from year to year and averaged
them. We totaled the averages in order to get the overall change from previous
relevant ratios and subtracted this number (1.94%) from the 11.025% average
to come up with a future growth rate of 9.08%.
Balance Sheet Forecasting Analysis
When forecasting the balance sheet previous changes in percentages
were relied on heavily. We calculated the percentages each line item was over
the past six years. We used the mean percentage to represent the real number
over the next 10 years, through the financials for 2016. The balance sheet was
based more off of assumptions than the income statement. We used the
forecasted net income as retained earnings on the balance sheet, which is one of
many assumptions. Another one, which has a little fact to back it up, was the
current asset to current liabilities ratio to predict the real numbers.
Year 2001 2002 2003 2004 2005 2006 Average
Total Assets/Total Liabilities 1.66 1.59 1.77 1.97 2.60 2.54 2.02
We computed the ratio for each year and then took the mean of the
output. This was 2.02, so for every dollar forecasted for the total liabilities we
gave 2.02 for the total assets. This shows Gap’s dedication in owner’s equity
and their lack of liabilities. The ratio for other companies within the industry was
much higher.
Inventory was another line item that used a little “guestimation.” Where
percentages were off in the financials, we gave the excess dollars to inventory.
The reason we did this was because over the past six years, Gap’s inventory has
been increasing at a little over two percent growth rate. This was computed by
calculating the mean of the percentage changes from the common size balance
sheet. Accounts Payable was another account that was difficult to forecast.
Over the years Accounts Payable was declining. We calculated it similar to
Inventory to account for our growth rate within net sales.
We did not forecast Property, Plant and Equipment due to the fact that
the company assigns it net of accumulated depreciation. The 10-K for Gap
shows they are constantly acquiring new assets, where as the net seems to be
declining over the years. The toss up between Property, Plant and Equipment
and other assets is hard to forecast.
Cash Flow Statement Forecast
The last statement we forecasted was the statement of cash flows. We
computed the ratio of CFFO/Sales using past financial statements. This ratio
showed trend and structure for the past 6 years because it did not fluctuate
much. We averaged the ratio over the past 6 years of financial statements we
had and that average was .10. We used this as the rate for our future cash from
operating activities.
We did not forecast the cash from investing activities because there was
no trend or structure to use in forecasting this number.
Method of Comparables
Valuation Methods
We have now built up to the section of the multiple valuation methods.
With the method of comparables to value Gap we took into account some of
Gap’s major competitors. The Methods of Comparables can be beneficial to Gap
Inc. because it allows Gap Inc. to compare themselves to their competitors by
showing the industry average. The comparables are beneficial to both Gap and
potential investors. Potential investors use the comparables because they are
quick and easy to compute and it also gives them an idea whether or not a
company is profitable. The various methods used are favored in the industry
because they are recent, easy to obtain and easy to compute. The downside
about these estimates is that they don’t always tell the truth and can be
misleading since we use the industry average. The reason the comparables can
be misleading is that an industry average is an estimate of the overall industry.
Using these estimates gives us an idea of where Gap Inc. should be in the
industry. There are several models that we used to help determine Gap Inc.’s
overall firm value. We got our information for our competitors’ financial
statements from yahoo.finance.com and for Gap’s we used their most recent 10-
K. We then used the average of the industry excluding Gap for each comparable
to estimate a price per share for Gap. This chart shows Gap Inc. compared to its
two main competitors in American Eagle and Abercrombie.
The graph below explains the various comparables of Gap Inc.,
Abercrombie and American Eagle. We used the ratios of Price to earnings, Price
over book value, dividend/price, PEG ratio, free cash flows, price over EBITDA
and equity value over EBITDA ratio to compare Gap to its competitors. After
analyzing the numbers from these ratios, we conclude that Gap is overvalued.
We will now discuss these ratios that these companies covet to determine their
value along with the industry value.
AEO ANF Industry Avg. GPS
P/E (trailing) 15.13 16.72 15.93 15.13
P/E (forecast) 12.09 12.84 12.47 12.47
P/B 4.24 4.92 4.58 4.58
D/P 0.025735 0.008614 0.017175 0.000006
P.E.G. 0.79 0.86 0.83 0.83
P/EBITDA 0.04 0.10 0.07 0.07
P/FCF -0.00039 0.00260 0.00111 NA
EV/EBITDA 7.11 7.86 7.48 7.34
Trailing Price to Earnings (Overvalued)
P/E TRAILING
RATIO P/E GPS EPS GPS PPS GPS P/E
AEO 15.13 0.94 14.22 15.13
ANF 16.72
Industry Avg. 15.925
Trailing Price to Earning was computed by dividing the Price Per Share (PPS)
over the Earnings Per Share (EPS). Trailing forecasting uses last year’s numbers
when computing this P/E ratio. With the trailing ratio we came up with an
estimated price for Gap at $14.22. With this too, we can conclude that Gap is
overvalued using this P/E trailing ratio. With the trailing ratio, it gave us a higher
estimated price but the price per share last year was little higher as well. The
Industry Average of American Eagle and Abercrombie was 15.93. Gap Inc.’s
trailing price to share that we computed was 15.13 which was very close to the
Industry Average.
Price to Earnings Forecast (Overvalued)
P/E FORECAST
RATIO P/E GPS EPS GPS PPS GPS P/E
AEO 12.09 0.94 11.71 12.465
ANF 12.84
Industry Avg. 12.465
To calculate the forecast P/E ratio we gathered the price per share and earnings
per share of Gap’s competitors and came up with an industry average excluding
Gap. With the Forecasted P/E though we have to use next year’s forecasted
numbers for the EPS while staying with the current PPS. We then used the
Industry average P/E times Gap’s earnings per share to calculate an estimated
price per share for Gap. Gap’s price was at $18.51 and we calculated it at
$11.72. For Gap Inc. we came up with their 12.47 for their P/E Forecast ratio.
We this we can conclude that this comparable tells us that Gap is overvalued.
Price to Book Ratio
P/B RATIO P/B GPS BPS GPS PPS GPS P/B
AEO 4.24 0.01 0.05 4.58
ANF 4.92
Industry Avg. 4.58
Price to Book Ratio is the price per share, current, (PPS) divided by the book
value equity (BVE). With the P/B model we used the numbers from
yahoo.finance.com to for competitors to get and industry average excluding Gap,
too. Then we used the industry average times Gap’s book value per share to
estimate a price of $13.65 when the actual price was at $18.51. This model also
supports the other ratios so far in telling us that Gap is overvalued.
Dividend/Price
D/P RATIO D/P GPS DPS GPS P GPS D/P
AEO 0.0000 -0.3251 -0.013264711 24.5086381
ANF 0.0086
Industry Avg. 0.0043
The dividend and price model is another method, which is only used for
screening signals. The Dividend over Price model is calculated by getting the
dividend and dividing it by the price. We took the Industry Avg. and divided it by
GPS DPS to get its price. Once we got the GPS P we ended up with a very low
D/P ratio. Although we don’t use this method for pricing the company, it still can
be a resourceful ratio. This method will tell us that Gap is undervalued.
Price Earnings Growth
PEG RATIO PEG
GPS Growth
Rate GPS GPS PEG
AEO 0.79 0.13 10.73 0.825
ANF 0.86
Industry Avg 0.825
The Price Earnings Growth (PEG) model is calculated by taking the P/E and
dividing by one minus the growth rate. Our growth rate was 13% for this model.
By doing this we calculated that GPS price earnings growth is at 0.83. According
to Investopedia, when the PEG ratio is greater than one it usually means that the
stock of the company is overvalued. This is because the stock is expected to
grow rapidly or very soon. Gap has a PEG ratio less than one which concludes
that it will not be expected to grow nearly as fast as it would if its ratio was
above the coveted one level.
Price/EBITDA
P/EBITDA RATIO P/EBITDA
GPS
EBITDA(millions) GPS P
GPS
P/EBITDA
AEO 0.038233392 1223 83.1369049 0.067977845
ANF 0.097722298
Industry Avg. 0.067977845
Price/EBITDA ratio is computed by the firm’s share price over the EBITDA. Our
price was at 83.14 We came up with the average of the industry. “EBITDA is a
good metric to evaluate profitability.” “EBITDA is often used as an accounting
gimmick to dress up a company's earnings” (Investopedia). The reason a
company would choose to dress up their earnings would make them look more
reliable.
Price/Free Cash Flows
P/FCF RATIO P/FCF GPS FCF GPS P
AEO -0.000385193 -2 NA
ANF 0.002598491
Industry Avg. 0.002598491
Computing a Price/Free Cash Flow ratio for Gap Inc. is impossible because we
come up with a negative number. Having a negative number for this ratio would
give the industry a false number. The higher the ratio means that the company
is considered to be of more value.
Enterprise Value/ EBITDA
EV/EBITDA RATIO EV/EBITDA
GPS
EBITDA(millions)
GPS
EV(millions)
GPS
EV/EBITDA
AEO 6.947 1223 8975.597 7.339
ANF 7.731
Industry Avg. 7.339
This ratio is dividing the enterprise value over the EBITDA. Coming up with the
enterprise value is step one, this is done by gathering common equity plus debt,
then we add in minority interest and preferred equity. After that we subtract
cash and cash equivalents. This gives us the enterprise value. We then divided
our enterprise value of 8975.60 over our EBITDA, giving us a 7.34 ratio.
Estimation of Cost of Capital
The cost of capital is an important measurement for a firm. In order to
estimate the cost of capital we used the capital asset pricing model (CAPM). To
use this model one has to know the beta of the firm, the risk free rate, and the
market rate premium. The beta can be found through performing a series of
regressions on the return of the firm and the market risk premium for different
time periods on the yield curve. The beta gives a firm an idea of how their value
reacts to the changes in the market. The market risk premium was computed by
subtracting Gap’s treasury from the SP 500, and the numbers used for the return
of the firm were found on yahoo finance. Through this regression analysis we
concluded that Gap’s beta is 1.64 compared to the published beta of .96 on
yahoo finance. This beta was the combination of the six month treasury and
seventy two observations or months. This particular beta was chosen because it
had the highest adjusted R square value of 25.9%. This infers that 25.9% of
risk is explained, which is not particularly high but is Gap’s best option. Over the
different periods on the yield curve, beta is not very stable. It ranges from .97
to 1.64 with explanation power from 7% to 25.8%. The fact that the betas are
very similar for the same spot on the yield curve using different treasuries
implies that Gap is more responsive to the market rather than interest rates.
Beta3 months 6 months 2 years 5 years 10 years
72 months 1.63 1.64 1.62 1.62 1.6160 months 1.3 1.3 1.3 1.29 1.2848 months 1.17 1.17 1.17 1.16 1.1636 months 0.98 0.97 0.97 0.97 0.9724 months 1.15 1.15 1.15 1.15 1.16
R Square3 months 6 months 2 years 5 years 10 years
72 months 0.255 0.259 0.253 0.252 0.25160 months 0.218 0.218 0.217 0.215 0.21448 months 0.08 0.08 0.079 0.077 0.07636 months 0.066 0.07 0.066 0.065 0.06524 months 0.087 0.087 0.088 0.089 0.089
For the risk free rate, the most recent treasuries found on the St. Louis
Federal Reserve were used. The risk free rate is the theoretical return expected
if a firm had no risk. From the numbers we acquired online we looked to see if
there was any kind of trend; which there was. The majority of the treasuries
fluctuated within a couple of points of 4.8; therefore that is the number chosen
for use in CAPM. Finally, the market risk premium which is the difference
between the risk of the industry and the risk free rate is a quantity that has
much debate. Historically it was said to be between 7-9% from 1926-2002
(Business Analysis and Evaluations 3rd edition). However, that amount takes
into account many wars and globalization that occurred during that time period.
Therefore many people argue that the market risk premium has dropped down
to around 3-5%. This lower measurement would be more accurate for high
technology companies or ones that are extremely globalized. While Gap is not in
the technology field they do conduct a good amount of business across seas;
therefore when finding the cost of capital for Gap a market risk premium of 4%
was used. After plugging all these numbers into CAPM Gap’s cost of capital
came out to 11.36%.
WACC Estimation
WACC(BT)= (Ve/Vf)Ke + (Vd/Vf)Kd
WACC(AT)= (Ve/Vf)Ke + (Vd/Vf)Kd (1-tax rate)
With the estimates of the cost of debt and cost of capital we were then
able to calculate the weighted average cost of capital before and after taxes.
Weighing cost of debt and cost of capital by the market value are essential to
calculate WACC. WACC gives analysts an idea of the profitability of the firm and
can also be used to compare Gap with other ratios in order to analyze them
against their competitors. It takes the assets of a firm and weighs them
according to whether they are financed by debt or equity, and tells investors the
average amount expected as a return of these two components. Companies
should have the majority financed by equity in order to stay in business and not
file bankruptcy. We used a corporate tax rate of 35%. The cost of debt in the
most recent 10-K stated at 6.9% was a reasonable estimate; therefore it was
used in computing WACC. The market value of equity was acquired by
multiplying the price per share by the number of shares outstanding, while the
book value of liabilities was used for the market value of liabilities. For the
before tax WACC we came up with 11.02 and for the after tax we calculated it to
be 7.16.
Intrinsic Valuation Models
Intrinsic valuation models are based on speculative assumptions on what
the stock price should be. We used the stock prices from June 1, 2007 to
compare our intrinsic values of stock prices to. Contrary to most companies,
after considering Gap, Inc.’s Method’s of Comparables against the Intrinsic
Valuation Models we found that the Methods of Comparables were more realistic
to Gap’s stock prices. Intrinsic Valuation Models are more thorough because
they have more details tying each ratio together. The Method’s of Comparables
only take at most three data facts and make a ratio to compare. The four
Intrinsic Valuation Models are the discounted dividends model, free cash flow
model, residual income model, and finally the abnormal earnings growth model.
Each model showed that Gap was extremely overvalued as you will easily
recognize in the sensitivity analysis charts to follow.
Free Cash Flows Valuation Model
The first of the intrinsic valuation models we used was the Free Cash
Flows Model. Through this model we found that Gap, Inc.’s stock price is
extremely overvalued. This model measures the discounted future cash flows to
evaluate a firm’s financial performance and capacity to sustain the firm’s assets.
Measuring free cash flows is important because you are measuring the amount
of money a firm has after they pay their necessary operating expenses or
overhead costs. This shows their potential to put the money into places that will
help the firm gain present value. To compute this model you use t, the number
of years forecasted out, and the forecasted cash investments. We got the cash
investments by finding the difference in Property, Plant and Equipment for the
different years. You use the formula 1/(1+weighted average cost of capital)^t
times the forecasted difference in the cash flows from operations and cash
investments to find the present value of free cash flows. The sum of these cash
flows and the infinite value of the perpetuity of FCF is equal to the value of the
firm. When you subtract the book value of the liabilities from the value of the
firm you get the shareholders worth from the firm. The difference between the
market and book value of liabilities is nominal and using the book value of
liabilities allows us to estimate the owner’s equity.
When evaluating Gap’s numbers within the Free Cash Flow Model, their
estimated price per share is extremely low. When using their historical property,
plant and equipment to come up with the cash investments, we ran into a huge
assumption. The number has been negative over the past 6 years; however,
they are growing closer and closer to zero. By next year according to the
percentage change on the common size balance sheet, the property plant and
equipment should become a positive number. The estimated book value of the
firm is also constantly growing. We used the Perpetuity Growth Rate of 10%
with Gap’s WACC of 11.02% to help us compute the intrinsic value, or estimated
price per share. We came up with $12.56 per share for the intrinsic value.
When running the sensitivity test, we realize that if the WACC was lower, around
5% then with a growth rate of 10 percent the firm would be considered
overvalued. Also if the company was valued with no weighted average cost of
capital, meaning free, then the company would be valued ideally within our plus
or minus 15% range no matter what the growth of free cash flows happened to
be.
Growth Rates
WACC 0 0.0594 0.1 0.12 0.150 $ 19.79 $ 19.79 $ 19.79 $ 19.79 $ 19.79
0.05 $ 9.21 $ 11.40 $ 23.90 n/a $ 0.98 0.1102 $ 3.66 $ 4.99 $ 12.56 N/A n/a
0.15 $ 1.16 $ 2.12 $ 7.64 n/a n/a 0.2 n/a n/a $ 3.27 n/a n/a
Our sensitivity test shows that with Gap’s FCF, Gap’s WACC would need to
be next to zero, which is impossible in today’s world. The model does not
support Gap’s stock prices nor does it seem realistic for Gap’s prices to be
$18.51. This model does not work well for Gap. On the sensitivity analysis, the
prices that are too low are shaded red. With these prices, you do not want to
purchase the stock because it is overvalued. The prices that are green are
where the stock is undervalued and you would want to purchase the stock. If
the values are labeled in yellow you would also consider purchasing the stock
because it is considered fairly valued. If the stock prices are $18.51 the 15%
leeway would be from $21.29 to $15.73.
Discounted Dividends Valuation Model
Another Intrinsic Valuation Model is the Discounted Dividends Model.
After analyzing this model we again noticed that Gap was extremely overvalued-
even worse than when analyzing the Free Cash Flow Model. Discounted
Dividends can be used to estimate all of the future cash flows to the investor in
order to estimate the share price for a corporation. This model uses the present
value of all future dividends paid out. When calculating this number for Gap, we
took future estimated cash flows and divided it by the current number of shares
outstanding. The reason we used this number was because the number of
shares has not had a traceable pattern. It would be forecasting the
unpredictable; however to do this model, we needed dividends per share and we
were forced to make the assumption that the shares remained constant. This
made each year forecasted skewed. While we did estimate the future dividends
per share as best as we could, there was no real trend to follow. This could
throw off this model millions of dollars. No investor should look at this model
when considering Gap because one important variable can not be predicted.
We found the present value, similar to the Free Cash Flow Formula
however we multiplied it by the future cash dividends paid. We also found the
present value of the perpetuity by taking year ten’s present value and multiplying
it by the year ten dividends divided by the cost of equity minus the perpetuity
growth rate. This shows the value of dividends forecasted out infinitely and
follows the assumption that dividends will continue to grow into the future as
they have in the past. While we do not agree with the forecasting methods used
to get the numbers for the sensitivity analysis, no numbers from the chart
remotely comes close to the price per share on June 1, 2007 which was $18.51.
The sensitivity model again shows how overvalued Gap, Inc. seems is.
Growth Rates
Ke 0 0.02 0.0594 0.06 0.08
0.09 $ 5.39
$ 5.93
$ 8.14
$ 8.21
$ 11.38
0.1 $ 5.05
$ 5.55
$ 7.60
$ 7.65
$ 10.58
0.1136 $ 4.61
$ 5.10
$ 6.94
$ 6.97
$ 9.58
0.12 $ 4.46
$ 4.88
$ 6.62
$ 6.67
$ 9.18
0.13 $ 4.20
$ 4.59
$ 6.20
$ 6.24
$ 8.54
When analyzing the sensitivity test, we used small increments on both
axis’s to see how large the change was for little change in variables. It would
take larger changes in the variables to bring the estimated stock price up to the
actual stock price. On the sensitivity analysis, the prices that are too low are
shaded red. With these prices, you do not want to purchase the stock because it
is overvalued. The prices that are green are where the stock is undervalued and
you would want to purchase the stock. If the values are not labeled you would
also consider purchasing the stock because it is considered fairly valued.
Residual Income Valuation Model
Another model of valuation is the Residual Income Valuation Model. This
model also showed that Gap, Inc. was overvalued. In this model you use actual
earnings compared to normal or expected earnings to find either the value added
to the company or the value destroyed during the previous year. We also used
the book value for the beginning year to show the progress/damage of residual
income. To find the beginning book value for Gap, we took the previous year’s
beginning balance of the book value for the firm added net earnings and
subtracted cash dividends paid. After finding the ending book value we found
the benchmark or normal by multiplying the cost of capital by the beginning
book value. Then, we took the net earnings and subtracted the benchmark
earnings. This number is the residual income. We do this for each year and take
the present value with the formula 1/ (1+Ke) ^t. Next, we found the present
value of all future residual incomes assuming it maintains our growth rate.
When you add the Initial book value to the present value of each annual residual
income and the present value of the perpetuity we get the estimated value of
the firm. By dividing this sum by the number of shares outstanding we get the
estimated price per share.
In this model we see that yet again Gap’s estimate price falls short of its
actual price per share. The actual price per share is 18.51 whereas the
estimated price under this model is only $7.00. This could possibly be because
of the estimated cost of capital is relatively high and makes the benchmark
earnings higher than the actual earnings. This leads to our residual income
being negative. In order for a company to operate under the assumption of a
corporation where it lasts infinitely, our growth rate must be negative for the
residual income to get closer and closer to zero. Using the formula for residual
income, the number will never get out of the negative numbers, however it is
unreasonable for the company to continually destroy more and more of the book
value. When the residual income is repeatedly further into the negatives, the
firm’s managers are destroying more and more value. It leads to grosser
residual income and looses estimated value until the company is not worth
anything. This is important in realizing that Gap’s managers are either not
making very good decisions or something external in the environment is driving
up the cost of capital and down the profits.
Growth Rate
Ke -0.27 -0.23 -0.19 -0.15 -0.10.09 $ 9.69 $ 9.65 $ 9.60 $ 9.54 $ 9.42 0.1 $ 8.56 $ 8.49 $ 8.41 $ 8.30 $ 8.10
0.1136 $ 7.23 $ 7.14 $ 7.00 $ 6.88 $ 6.61 0.12 $ 6.68 $ 6.58 $ 6.46 $ 6.30 $ 6.01 0.13 $ 5.91 $ 5.80 $ 5.67 $ 5.49 $ 5.19
When looking at the sensitivity analysis for this model, I used the 15
percent of actual share price for grounds to measure the sensitivity against. The
estimated prices that are below value have been shaded red. This means that
the actual share price is extremely high for what the residual income valuation
model says the intrinsic share price should be. You would not want to purchase
the stock because it is overvalued. If there were any prices shaded green are
where the stock is undervalued and you would want to purchase the stock. Here
the residual income model is telling you the share price should be higher that it
actually is and you should consider purchasing. If the values were labeled yellow
you would also consider purchasing the stock because it is considered fairly
valued. With the growth rates given, it is easy to see that this company is not
worth buying due to the low intrinsic share prices.
Long-Run Residual Income Perpetuity The Long-run residual income perpetuity model is another model used to
value a company. This model is similar to the residual income model in that it
still looks at the value added or value destroying aspects of a firm but the long-
run residual income perpetuity calculates the perpetuity of residual income to
derive a value for stock price. To calculate the long-run residual income
perpetuity we used to following formula:
Intrinsic Value=BVE0*[1+(ROE-Ke)/(Ke-g)]
According to the model it was necessary to calculate a long-run return on
equity which was calculated by taking our forecasted return on equity and
finding the average which was .0804. Another necessary calculation was finding
the long-run growth rate in equity. To find this growth rate we took the
percentage changes in our forecasted return on equity calculations and found an
average of -.0187. Our cost of equity calculation was 11.36% which we found
when doing the regression analysis.
Sensitivity Analysis
<$20.00 Over Valued
>$20.00 Under Valued
$16.00-$25.00
Fair Valued
Growth 0 0.02 0.04 0.06 0.07 ROE 0.2 1.11 0 na na na
0.3 16.71 18.95 22.42 28.51 32.43 0.4 22.29 25.72 31.04 40.38 48.32 0.5 27.85 32.49 39.67 52.06 62.95 0.6 33.43 39.26 48.3 64.14 77.59
ROE
0.2 0.25 0.3 0.35 0.4 Ke 0.08 25.18 33.05 40.9 48.79 56.66
0.09 20.15 20.33 32.73 39.03 45.32 0.105 15.49 15.05 25.18 30.02 34.87 0.12 12.59 16.52 20.46 24.4 28.33
0.135 10.6 13.92 17.23 20.54 23.86
Growth 0 0.02 0.04 0.06 0.07 Ke 0.08 23.61 29.38 40.92 75.55 144.8
0.09 20.98 25.18 32.73 50.37 72.4 0.105 17.99 20.73 25.18 33.58 41.37 0.12 15.73 17.63 20.46 25.18 28.96
0.135 13.99 15.33 17.23 20.14 22.73
We used 3 different tables for long-run residual income perpetuity
sensitivity analysis since there were 3 different variables that needed comparing.
First we used our cost of equity and growth rate to estimate share price, keeping
ROE constant. Then we used ROE and cost of equity to compute estimated
share price while keeping our growth rate constant. Lastly, we used ROE and
our growth rate to computer estimated share price while keeping cost of equity
constant. Our estimated share price given the model was $18.92. Our upper
bound share price above any estimation of share price above this number
showed Gap to be undervalued and our lower bound share price was $20.00
which means any estimation of share price below this number shows Gap to be
overvalued. Using the model, our estimates turn out to be fairly valued a
majority of the time. There were still a few instances where our estimates for
share price based on this model showed Gap Inc. to be overvalued or
undervalued.
The Abnormal Earnings Growth Model
The AEG model is by far a more accurate estimation than all the models
we have presented. The AEG model is calculated by taking the dividends and
earnings, in this case we used Gap financials from 10-K to work this model. We
first calculate the DRIP by taking the previous years dividends per share times
cost of capital (Ke). We then calculate the Cumulative Dividends Earnings (CDI)
by adding the the DRIP and CDI. We must then calculate the benchmark by the
previous year’s earnings per share times one plus cost of capital (Ke). After this
step, we can calculate the annual AEG by subtracting the benchmark from the
CDI. We then used the cost of capital to find the present value factor and then
multiplied by annual AEG to get the present value of AEG. We then found the
present value of the terminal value with the present value factor to get to this
important step. We then took the present value and the earnings per share for
Gap’s 2007 to get it to present value dollars. We made sure to discount back to
June 1, 2007.
The price that we came up with was 7.74 which strongly determine that
Gap is overvalued along with the other models. In the sensitivity analysis Gap is
overvalued through all the analysis. When the cost of capital decreases below
the federal funds rate, it tells us that Gap is undervalued. It is very unlikely,
though, that the cost of capital we go below the federal funds rate. The cost of
capital will always be above the federal funds rate. The AEG model adds value to
its perpetuity which helps us play with different numbers to get different
estimates. For example when the growth is zero, we conclude that Gap’s
earnings per share will be kept forever.
In conclusion we have used these entire models to evaluate Gap Inc. All
these models overall have indicated that Gap Inc. is overvalued. Some have
showed different estimates, some more accurate than others. For the most part,
all of these models gave us a better picture where Gap Inc. stands against its
industry.
Atman Z- Score
2002 2003 2004 2005 2006 Z SCORE 2.8410 3.2638 3.7216 4.2305 4.1613
Formula
Z-score=1.2 (working capital/total assets)+1.4 (retained earnings/total
assets)+3.3 (EBIT/total assets)+0.6 (market value of equity/book value of
liabilities) +1.0 (sales/total assets)
After calculating the z-score for gap we can conclude that they are a low
credit risk company. When their z-score is below 2.3 it is considered to be a
high credit risk and would be almost in bankrupt. In this case they have
maintained to be above a 3 z-score after 2002, which mean they are less risky to
go to bankrupt. The higher the z-score the better the company will be able to
pay their debt.
APPENDIX Current Ratio 2002 2003 2004 2005 2006Gap 1.48 2.11 2.68 4.48 4.54Abercrombie 2.84 2.42 1.58 1.93 2.14American Eagle 3.01 2.54 3.27 3.06 2.6
Quick Asset Ratio 2002 2003 2004 2005 2006Gap 1.24 1.84 1.82 2.44Abercrombie 1.95 1.7 0.91 1.02 1.12American Eagle 1.47 0.77 1.19 0.45 0.19
Inventory Turnover 2002 2003 2004 2005 2006Gap 4.74 5.8 5.45 5.99 5.73Abercrombie 6.52 5.8 3.22 2.57 2.59American Eagle 7.38 8.01 7.31 5.9 5.51
Days supply of inventory 2002 2003 2004 2005 2006Gap 77.00 62.93 66.97 60.93 63.70Abercrombie 55.98 62.93 113.35 142.02 140.93American Eagle 49.46 45.57 49.93 61.86 66.24 Working Capital Turnover 2002 2003 2004 2005 2006Gap, Inc. 14.00 5.26 4.00 4.86 5.78Abercrombie 4.09 3.87 8.48 6.11 5.71American Eagle 5.13 4.72 3.29 3.20 3.79Industry Average 4.61 4.30 5.89 4.66 4.75 Gross Profit Margin 2002 2003 2004 2005 2006Gap, Inc. 33.99% 37.64% 39.23% 36.63% 35.43%Abercrombie 41.1% 42.0% 66.3% 66.5% 66.5%American Eagle 37% 36% 47% 46% 48%Average 39% 39% 57% 56% 57% Operating Profit Margin 2002 2003 2004 2005 2006Gap, Inc. 7.00% 11.85% 12.82% 10.89% 7.36%Abercrombie 19.6% 19.4% 17.2% 19.5% 19.8%American Eagle 10% 7% 19% 20% 21%Average 15% 13% 18% 20% 20%
Net Profit margin 2002 2003 2004 2005 2006Gap, Inc. 3.30% 6.50% 7.07% 6.95% 4.88%Abercrombie 12.2% 12.7% 12.0% 12.0% 12.7%American Eagle 6% 4% 11% 13% 14%Average 9% 8% 12% 13% 13% Asset Turnover 2002 2003 2004 2005 2006Gap, Inc. 0.71 0.75 0.78 0.85 0.92Abercrombie 0.9 0.72 0.74 0.89 0.82American Eagle 0.2 0.18 0.85 0.8 0.78Average 0.55 0.45 0.795 0.845 0.8 Return on Assets 2002 2003 2004 2005 2006Gap, Inc. 4.82% 9.96% 10.73% 11.08% 8.82%Abercrombie 25.30% 21.80% 15.60% 24.80% 23.60%American Eagle 13.19% 8.09% 22.88% 22.74% 24.12%Industry Average 19.25% 14.95% 19.24% 23.77% 23.86% Return on Equity 2002 2003 2004 2005 2006Gap, Inc. 13.04% 21.53% 24.74% 22.55% 14.34%Abercrombie 26.00% 28.90% 25.20% 49.90% 42.40%American Eagle 17.67% 10.39% 33.47% 30.53% 33.52%Industry Average 21.84% 19.65% 29.34% 40.22% 37.96% Debt to Equity Ratio 2002 2003 2004 2005 2006 Gap 0.65 0.63 1.04 1.3 1.16 Abercrombie 0.327 0.613 1.01 0.8 0.6 American Eagle 0.28 0.46 0.34 0.39 0.4 Average 0.3035 0.5365 0.675 0.595 0.5 Times Interest Ratio 2002 2003 2004 2005 2006 Gap 0.28 0.43 0.44 0.41 0.21 Abercrombie 82.89 89.44 66.62 81.32 47.36 Debt Service Margin 2002 2003 2004 2005 2006 Gap 1.1 1.25 1.36 1.86 1.12 Abercrombie 6.9 5.89 5.17 5.24 5.77 American Eagle na 3.74 5.17 6.29 1.38 Average 6.9 4.815 5.17 5.765 3.575
Internal Growth Rate 2002 2003 2004 2005 2006 averagesGap, Inc. 10.23% 11.92% 11.47% 10.67% 5.93% 10.04%American Eagle 12.00% 6.00% 16.66% 20.57% 22.02% 15.45%Abercrombie 25.30% 21.80% 18.95% 28.68% 27.04% 24.35%Average 18.65% 13.90% 17.81% 24.63% 24.53% 19.90% Sustainable Growth Rate 2002 2003 2004 2005 2006 averagesGap, Inc. 16.87% 19.43% 23.39% 24.53% 12.81% 19.41%American Eagle 15.36% 8.76% 22.33% 28.60% 30.82% 21.17%Abercrombie 32.74% 28.93% 30.56% 57.64% 48.68% 39.71%Average 24.05% 18.84% 26.45% 43.12% 39.75% 30.44% PP&E turnover 2002 2003 2004 2005 2006 Gap 3.83 4.37 4.82 4.94 4.99 Abercrombie 4.06 2.71 2.94 3.42 3.04 American Eagle 5.47 4.46 5.35 6.72 5.8 Average 4.77 3.59 4.15 5.07 4.42 CFFO/CL 2002 2003 2004 2005 2006 Gap 0.456 0.848 0.712 0.799 0.55 Abercrombie 1.635 1.101 1.024 0.923 1.14 American Eagle 0.738 0.907 1.456 1.367 1.627 Average 1.1865 1.004 1.24 1.145 1.3835
3 MONTH REGRESSION
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.515448R Square 0.265687Adjusted R Square 0.255197Standard Error 0.100644Observations 72
ANOVAdf SS MS F ignificance F
Regression 1 0.256546 0.256546 25.3272 3.6E-06Residual 70 0.709048 0.010129Total 71 0.965593
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.003118 0.011862 0.262875 0.793419 -0.020539 0.026776 -0.020539 0.026776X Variable 1 1.628443 0.323578 5.032613 3.6E-06 0.983087 2.273798 0.983087 2.273798
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.481087R Square 0.231445Adjusted R Square 0.218194Standard Error 0.082794Observations 60
ANOVAdf SS MS F ignificance F
Regression 1 0.119728 0.119728 17.46628 9.98E-05Residual 58 0.39758 0.006855Total 59 0.517308
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.004152 0.010752 0.386182 0.700775 -0.01737 0.025674 -0.01737 0.025674X Variable 1 1.300848 0.311262 4.179268 9.98E-05 0.677789 1.923906 0.677789 1.923906
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.314786R Square 0.09909Adjusted R Square 0.079505Standard Error 0.078198Observations 48
ANOVAdf SS MS F ignificance F
Regression 1 0.030939 0.030939 5.059509 0.029321Residual 46 0.281288 0.006115Total 47 0.312227
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept -0.003432 0.012004 -0.285933 0.776213 -0.027596 0.020731 -0.027596 0.020731X Variable 1 1.174285 0.522059 2.249335 0.029321 0.123435 2.225134 0.123435 2.225134
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.304445R Square 0.092687Adjusted R Square 0.066001Standard Error 0.063161Observations 36
ANOVAdf SS MS F ignificance F
Regression 1 0.013856 0.013856 3.473288 0.071022Residual 34 0.135636 0.003989Total 35 0.149492
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept -0.007762 0.01089 -0.712821 0.48082 -0.029893 0.014368 -0.029893 0.014368X Variable 1 0.975138 0.523234 1.863676 0.071022 -0.088201 2.038477 -0.088201 2.038477
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.356182R Square 0.126866Adjusted R Square 0.087178Standard Error 0.058562Observations 24
p;;ANOVA
df SS MS F ignificance FRegression 1 0.010963 0.010963 3.196588 0.087576Residual 22 0.075449 0.003429Total 23 0.086411
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept -0.012098 0.012741 -0.94951 0.352676 -0.038522 0.014326 -0.038522 0.014326X Variable 1 1.149695 0.643042 1.787901 0.087576 -0.183892 2.483282 -0.183892 2.483282
6 MONTH REGRESSION
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.519028R Square 0.26939Adjusted R Square 0.258953Standard Error 0.10039Observations 72
ANOVAdf SS MS F ignificance F
Regression 1 0.260122 0.260122 25.8104 3E-06Residual 70 0.705472 0.010078Total 71 0.965593
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.003222 0.011832 0.272296 0.786196 -0.020376 0.026819 -0.020376 0.026819X Variable 1 1.641512 0.323107 5.080394 3E-06 0.997095 2.285929 0.997095 2.285929
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.48136R Square 0.231708Adjusted R Square 0.218461Standard Error 0.08278Observations 60
ANOVAdf SS MS F ignificance F
Regression 1 0.119864 0.119864 17.49209 9.88E-05Residual 58 0.397444 0.006852Total 59 0.517308
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.004308 0.010746 0.400932 0.689943 -0.017202 0.025818 -0.017202 0.025818X Variable 1 1.301464 0.31118 4.182354 9.88E-05 0.67857 1.924357 0.67857 1.924357
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.315019R Square 0.099237Adjusted R Square 0.079655Standard Error 0.078192Observations 48
ANOVAdf SS MS F ignificance F
Regression 1 0.030985 0.030985 5.067829 0.029195Residual 46 0.281242 0.006114Total 47 0.312227
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept -0.003259 0.011976 -0.272106 0.786758 -0.027366 0.020848 -0.027366 0.020848X Variable 1 1.17387 0.521446 2.251184 0.029195 0.124254 2.223486 0.124254 2.223486
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.30441R Square 0.092666Adjusted R Square 0.065979Standard Error 0.063162Observations 36
ANOVAdf SS MS F ignificance F
Regression 1 0.013853 0.013853 3.472408 0.071057Residual 34 0.135639 0.003989Total 35 0.149492
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept -0.007588 0.010866 -0.698332 0.489719 -0.029672 0.014495 -0.029672 0.014495X Variable 1 0.97421 0.522802 1.86344 0.071057 -0.088251 2.036671 -0.088251 2.036671
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.356361R Square 0.126993Adjusted R Square 0.087311Standard Error 0.058558Observations 24
ANOVAdf SS MS F ignificance F
Regression 1 0.010974 0.010974 3.200252 0.087406Residual 22 0.075438 0.003429Total 23 0.086411
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept -0.011934 0.012708 -0.939087 0.357883 -0.038289 0.014421 -0.038289 0.014421X Variable 1 1.149723 0.64269 1.788925 0.087406 -0.183133 2.48258 -0.183133 2.48258
2 YEAR REGRESSION
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.51376R Square 0.26395Adjusted R Square 0.253435Standard Error 0.100763Observations 72
ANOVAdf SS MS F ignificance F
Regression 1 0.254868 0.254868 25.1022 3.92E-06Residual 70 0.710725 0.010153Total 71 0.965593
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.003914 0.011875 0.329602 0.742685 -0.01977 0.027598 -0.01977 0.027598X Variable 1 1.620887 0.323517 5.01021 3.92E-06 0.975653 2.266121 0.975653 2.266121
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.479925R Square 0.230328Adjusted R Square 0.217057Standard Error 0.082854Observations 60
ANOVAdf SS MS F ignificance F
Regression 1 0.11915 0.11915 17.35673 0.000104Residual 58 0.398157 0.006865Total 59 0.517308
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.004733 0.010745 0.440499 0.661213 -0.016776 0.026243 -0.016776 0.026243X Variable 1 1.295458 0.310949 4.166141 0.000104 0.673026 1.91789 0.673026 1.91789
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.313477R Square 0.098268Adjusted R Square 0.078665Standard Error 0.078234Observations 48
ANOVAdf SS MS F ignificance F
Regression 1 0.030682 0.030682 5.012921 0.030038Residual 46 0.281545 0.006121Total 47 0.312227
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept -0.002909 0.011938 -0.24364 0.808593 -0.026938 0.021121 -0.026938 0.021121X Variable 1 1.16764 0.521511 2.238955 0.030038 0.117893 2.217388 0.117893 2.217388
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.30394R Square 0.092379Adjusted R Square 0.065685Standard Error 0.063172Observations 36
ANOVAdf SS MS F ignificance F
Regression 1 0.01381 0.01381 3.460587 0.071516Residual 34 0.135682 0.003991Total 35 0.149492
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept -0.007415 0.010846 -0.683662 0.498822 -0.029458 0.014627 -0.029458 0.014627X Variable 1 0.970172 0.521524 1.860265 0.071516 -0.089691 2.030035 -0.089691 2.030035
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.357672R Square 0.127929Adjusted R Square 0.08829Standard Error 0.058526Observations 24
ANOVAdf SS MS F ignificance F
Regression 1 0.011055 0.011055 3.227309 0.086165Residual 22 0.075357 0.003425Total 23 0.086411
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept -0.01202 0.012712 -0.945514 0.354666 -0.038383 0.014344 -0.038383 0.014344X Variable 1 1.152674 0.641633 1.796471 0.086165 -0.17799 2.483339 -0.17799 2.483339
5 YEAR REGRESSION
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.512494R Square 0.26265Adjusted R Square 0.252116Standard Error 0.100852Observations 72
ANOVAdf SS MS F ignificance F
Regression 1 0.253613 0.253613 24.93452 4.18E-06Residual 70 0.71198 0.010171Total 71 0.965593
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.00487 0.011888 0.409672 0.683298 -0.018839 0.028579 -0.018839 0.028579X Variable 1 1.615468 0.323518 4.993448 4.18E-06 0.970233 2.260704 0.970233 2.260704
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.477849R Square 0.22834Adjusted R Square 0.215035Standard Error 0.082961Observations 60
ANOVAdf SS MS F ignificance F
Regression 1 0.118122 0.118122 17.1626 0.000113Residual 58 0.399186 0.006883Total 59 0.517308
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.005445 0.010745 0.506799 0.614217 -0.016062 0.026953 -0.016062 0.026953X Variable 1 1.288929 0.311127 4.142776 0.000113 0.666141 1.911717 0.666141 1.911717
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.311158R Square 0.09682Adjusted R Square 0.077185Standard Error 0.078297Observations 48
ANOVAdf SS MS F ignificance F
Regression 1 0.03023 0.03023 4.931131 0.031342Residual 46 0.281997 0.00613Total 47 0.312227
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept -0.002375 0.01188 -0.199873 0.842461 -0.026289 0.021539 -0.026289 0.021539X Variable 1 1.161823 0.523199 2.220615 0.031342 0.108679 2.214968 0.108679 2.214968
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.303375R Square 0.092036Adjusted R Square 0.065331Standard Error 0.063184Observations 36
ANOVAdf SS MS F ignificance F
Regression 1 0.013759 0.013759 3.446431 0.072071Residual 34 0.135733 0.003992Total 35 0.149492
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept -0.007211 0.010824 -0.666216 0.509768 -0.029207 0.014785 -0.029207 0.014785X Variable 1 0.967036 0.520904 1.856457 0.072071 -0.091569 2.025641 -0.091569 2.025641
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.358415R Square 0.128461Adjusted R Square 0.088846Standard Error 0.058508Observations 24
ANOVAdf SS MS F ignificance F
Regression 1 0.0111 0.0111 3.242706 0.085468Residual 22 0.075311 0.003423Total 23 0.086411
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept -0.012059 0.012713 -0.948602 0.353128 -0.038424 0.014305 -0.038424 0.014305X Variable 1 1.154945 0.641368 1.800751 0.085468 -0.175172 2.485062 -0.175172 2.485062
10 YEAR REGRESSION
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.51158R Square 0.261714Adjusted R Square 0.251167Standard Error 0.100916Observations 72
ANOVAdf SS MS F ignificance F
Regression 1 0.25271 0.25271 24.81426 4.38E-06Residual 70 0.712883 0.010184Total 71 0.965593
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.005622 0.011899 0.472506 0.638035 -0.018109 0.029354 -0.018109 0.029354X Variable 1 1.612742 0.323753 4.981391 4.38E-06 0.967037 2.258448 0.967037 2.258448
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.476325R Square 0.226885Adjusted R Square 0.213556Standard Error 0.083039Observations 60
ANOVAdf SS MS F ignificance F
Regression 1 0.117369 0.117369 17.0212 0.00012Residual 58 0.399938 0.006895Total 59 0.517308
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept 0.006055 0.010744 0.563598 0.575201 -0.015451 0.027562 -0.015451 0.027562X Variable 1 1.28469 0.311389 4.125675 0.00012 0.661377 1.908003 0.661377 1.908003
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.309592R Square 0.095847Adjusted R Square 0.076192Standard Error 0.078339Observations 48
ANOVAdf SS MS F ignificance F
Regression 1 0.029926 0.029926 4.876355 0.03225Residual 46 0.282301 0.006137Total 47 0.312227
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept -0.0019 0.011828 -0.160676 0.873052 -0.025708 0.021908 -0.025708 0.021908X Variable 1 1.158238 0.524506 2.208247 0.03225 0.102463 2.214013 0.102463 2.214013
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.303334R Square 0.092012Adjusted R Square 0.065306Standard Error 0.063184Observations 36
ANOVAdf SS MS F ignificance F
Regression 1 0.013755 0.013755 3.445413 0.072111Residual 34 0.135737 0.003992Total 35 0.149492
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept -0.006989 0.010797 -0.647299 0.521785 -0.028931 0.014953 -0.028931 0.014953X Variable 1 0.966389 0.520633 1.856182 0.072111 -0.091664 2.024442 -0.091664 2.024442
SUMMARY OUTPUT
Regression StatisticsMultiple R 0.359214R Square 0.129034Adjusted R Square 0.089445Standard Error 0.058489Observations 24
ANOVAdf SS MS F ignificance F
Regression 1 0.01115 0.01115 3.259322 0.084723Residual 22 0.075261 0.003421Total 23 0.086411
Coefficientstandard Erro t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%Intercept -0.011995 0.012693 -0.944996 0.354925 -0.038319 0.014329 -0.038319 0.014329X Variable 1 1.157951 0.641396 1.805359 0.084723 -0.172224 2.488126 -0.172224 2.488126
Discounted Dividends Approach WACC(bT) 0.1102 Kd 0.069 Ke 0.1136Perp
0 1 2 3 4 5 6 7 8 9 102006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Net Earnings 778.00$ $832.77 $891.40 $954.15 $1,021.33 $1,093.23 $1,170.19 $1,252.57 $1,340.75 $1,435.14 $1,536.17DPS (Dividends Per Share) 0.34 0.36 0.39 0.42 0.45 0.48 0.51 0.54 0.58 0.62Book Value Equity $8,544.00 $9,621.95 $10,495.62 $11,448.62 $12,488.16 $13,622.08 $14,858.97 $16,208.16 $17,679.86 $19,285.19 $21,036.29Cash From Operations $1,250.00 $1,375.00 $1,512.50 $1,663.75 $1,830.13 $2,013.14 $2,214.45 $2,435.90 $2,679.49 $2,947.43 $3,242.18Cash Investments 179.15$ 189.19$ 199.79$ 210.98$ 222.80$ 235.29$ 248.47$ 262.40$ 277.10$ 292.63$
PV Factor 0.95615762 0.806383356 0.724122985 0.650254118 0.583920723 0.524354098 0.47086395 0.42283042 0.3796969 0.340963411PV Dividends Year by Year 0.326 0.294 0.282 0.271 0.260 0.250 0.240 0.230 0.221 0.212Total PV of Annual Dividends 2.584Continuing (Terminal) Value Perpetuity 11.465001PV of Terminal Value Perpetuity 4.353225Estimated Price per Share (end of 2006) 6.937
Observed Share Price $18.51Initial Cost of Equity (You Derive) 11.36%Perpetuity Growth Rate (g) 5.94%
G 0 0.02 0.0594 0.06 0.080.09 5.39$ 5.93$ 8.14$ 8.21$ 11.38$
0.1 5.05$ 5.55$ 7.60$ 7.65$ 10.58$ Ke 0.1136 4.61$ 5.10$ 6.94$ 6.97$ 9.58$
0.12 4.46$ 4.88$ 6.62$ 6.67$ 9.18$ 0.13 4.20$ 4.59$ 6.20$ 6.24$ 8.54$
free cash flows WACC(bT) 0.1102 Kd 0.069 Ke 0.1136
0 1 2 3 4 5 6 7 8 9 102006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
EPS (Earnings Per Share) 778.00$ $832.77 $891.40 $954.15 $1,021.33 $1,093.23 $1,170.19 $1,252.57 $1,340.75 $1,435.14 $1,536.17DPS (Dividends Per Share) 283.29 302.83 323.73 346.06 369.97 395.47 422.76 451.83 483.11 516.44BPS (Book Value Equity per Share) $8,544.00 $9,621.95 $10,495.62 $11,448.62 $12,488.16 $13,622.08 $14,858.97 $16,208.16 $17,679.86 $19,285.19 $21,036.29Cash From Operations $1,250.00 $1,375.00 $1,512.50 $1,663.75 $1,830.13 $2,013.14 $2,214.45 $2,435.90 $2,679.49 $2,947.43 $3,242.18Cash Investments 179.15$ $189.19 $199.79 $210.98 $222.80 $235.29 $248.47 $262.40 $277.10 $292.63Book Value of Debt and Preferred Stock $8,544
Annual Free Cash Flow $1,195.85 $1,323.31 $1,463.96 $1,619.15 $1,790.34 $1,979.16 $2,187.43 $2,417.09 $2,670.33 $2,949.55 0PV Factor 0.9007 0.8113 0.7308 0.6583 0.5929 0.5341 0.4811 0.4333 0.3903 0.3516PV of Free Cash Flows $1,077.15 $1,073.64 $1,069.86 $1,065.81 $1,061.52 $1,057.00 $1,052.26 $1,047.33 $1,042.21 $1,036.92Total PV of Annual Free Cash Flows $10,583.70 55.76%Continuing (Terminal) Value Perpetuity $21,516.87PV of Terminal Value Perpetuity $8,397.85 44.24%Value of Firm $18,981.55 100.00%Book Value of Liabilities $8,544Estimated Market Value of Equity $10,437.55Number of Shares 831.087Estimated Price per Share $12.56 intrinsic value
Observed Share Price $18.51 $21.29 $15.73Initial WACC 11.02%Perpetuity Growth Rate (g) 10.00%
growth rates 0 0.0594 0.1 0.12 0.150 19.79$ 19.79$ 19.79$ 19.79$ 19.79$
0.05 9.21$ 11.40$ 23.90$ n/a 0.98$ WACC 0.1102 3.66$ 4.99$ 12.56$ N/A n/a
0.15 1.16$ 2.12$ 7.64$ n/a n/a0.2 n/a n/a 3.27$ n/a n/a
WACC(bT) 0.1102 Kd 0.069 Ke 0.1136
0 1 2 3 4 5 6 7 8 9 102006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Net Earnings 778.00$ $832.77 $891.40 $954.15 $1,021.33 $1,093.23 $1,170.19 $1,252.57 $1,340.75 $1,435.14 $1,536.17Dividends Per Share 283.29 302.83 323.73 346.06 369.97 395.47 422.76 451.83 483.11 516.44Book Value Per Share $8,544.00 $9,621.95 $10,495.62 $11,448.62 $12,488.16 $13,622.08 $14,858.97 $16,208.16 $17,679.86 $19,285.19 $21,036.29
Actual Earnings $832.77 $891.40 $954.15 $1,021.33 $1,093.23 $1,170.19 $1,252.57 $1,340.75 $1,435.14 $1,536.17"Normal" (Benchmark) Earnings $970.60 $1,093.05 $1,192.30 $1,300.56 $1,418.65 $1,547.47 $1,687.98 $1,841.25 $2,008.43 $2,190.80Residual Income (Annual) ($137.83) ($201.65) ($238.15) ($279.23) ($325.42) ($377.28) ($435.41) ($500.50) ($573.29) ($654.63)PV Factor 0.95615762 0.85861855 0.724123 0.6502541 0.58392072 0.5243541 0.47086395 0.42283042 0.3796969 0.340963411PV of Annual Residual Income ($131.79) ($173.14) ($172.45) ($181.57) ($190.02) ($197.83) ($205.02) ($211.63) ($217.68) ($223.20)Total PV of Annual Residual Income ($1,904.33)Continuing (Terminal) Value Perpetuity -$2,156.22PV of Terminal Value Perpetuity -$818.71 -0.98510618Initial Book Value of Equity $8,544.00
Estimated Value (end of 2006) $5,820.96Estimated Price per share $7.00Number of Shares 831.087Observed Share Price $18.51Initial Cost of Equity (You Derive) 11.36%Perpetuity Growth Rate (g) -19.00%
growth rate -0.27 -0.23 -0.19 -0.15 -0.10.09 9.69$ 9.65$ 9.60$ 9.54$ 9.42$
0.1 8.56$ 8.49$ 8.41$ 8.30$ 8.10$ 0.1136 7.23$ 7.14$ 7.00$ 6.88$ 6.61$
0.12 6.68$ 6.58$ 6.46$ 6.30$ 6.01$ 0.13 5.91$ 5.80$ 5.67$ 5.49$ 5.19$
Book Value of Equity 5.17E+09Long Run Return on Equity 0.3Long Run Growth Rate in Equity 0.08Cost of Equity 0.113
Estimated Price per Share 41.97102
Observed Share Price $18.51
821837000 Shares Outstanding Growth0 0.02 0.04 0.06 0.07
ROE 0.2 1.11 0 na na na0.3 16.71 18.95 22.42 28.51 32.430.4 22.29 25.72 31.04 40.38 48.320.5 27.85 32.49 39.67 52.06 62.950.6 33.43 39.26 48.3 64.14 77.59
Ke at 11.3 %
ROE0.2 0.25 0.3 0.35 0.4
Ke 0.08 25.18 33.05 40.9 48.79 56.660.09 20.15 20.33 32.73 39.03 45.32
0.105 15.49 15.05 25.18 30.02 34.870.12 12.59 16.52 20.46 24.4 28.33
0.135 10.6 13.92 17.23 20.54 23.86
Growth at 4%
Growth0 0.02 0.04 0.06 0.07
Ke 0.08 23.61 29.38 40.92 75.55 144.80.09 20.98 25.18 32.73 50.37 72.4
0.105 17.99 20.73 25.18 33.58 41.370.12 15.73 17.63 20.46 25.18 28.96
0.135 13.99 15.33 17.23 20.14 22.73
ROE at 30%
<$20.00 Over Valued>$20.00 Under Valued$16.00-25.00 Fair Valued
WACC(AT) 0.1102 Kd 0.069 Ke 0.1136
0 1 2 3 4 5 6 7 8 9 102006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
EPS (Earnings Per Share) 778.00$ $832.77 $891.40 $954.15 $1,021.33 $1,093.23 $1,170.19 $1,252.57 $1,340.75 $1,435.14 $1,536.17DPS (Dividends Per Share) 256 283.29 302.83 323.73 346.06 369.97 395.47 422.76 451.83 483.11 516.44
Annual Income 778.00$ $832.77 $891.40 $954.15 $1,021.33 $1,093.23 $1,170.19 $1,252.57 $1,340.75 $1,435.14 $1,536.17Drip Income 29.0816 32.181744 34.401488 36.775728 39.312416 42.028592 44.925392 48.025536 51.327888 54.881296Cumulative Dividend Income $861.85 $923.58 $988.55 $1,058.11 $1,132.54 $1,212.22 $1,297.50 $1,388.78 $1,486.47 $1,591.05"Normal" Annual Income (Benchmark) 866.3808 927.372672 992.66304 1062.54144 1137.353088 1217.420928 1303.123584 1394.861952 1493.0592 1598.171904Annual AEG ($4.53) ($3.79) ($4.11) ($4.44) ($4.81) ($5.20) ($5.63) ($6.09) ($6.59) ($7.12)PV Factor 0.89798851 0.80638336 0.72412299 0.650254118 0.583920723 0.524354098 0.470863953 0.422830417 0.379696855 0.340963411PV AEG (Annual) ($4.07) ($3.06) ($2.98) ($2.88) ($2.81) ($2.73) ($2.65) ($2.57) ($2.50) ($2.43)Total PV of AEG ($0.03)Core Perpetuity Earnings -0.02285882Core Eps 0.94$ Total Earnings Perpetuity $0.88Capitalization Rate (Ke) 0.1136Estimated Price per Share (end of 1987) $7.74
Observed Share Price $18.51Perpetuity Growth Rate (g) -0.19
References
• Gap Inc. 10 K 2002-2007
• Abercrombie and Fitch 10 K 2002-2007
• American Eagle 10 K 2002-2007
• www.finance.yahoo.com
• www.mindtools.com
• WSJ “For US Firms a Global Makeover”
• www.pacsun.com
• WSJ “Gap Hires a High End Designer”
• Business Analysis & Valuation, third edition
• www.gapinc.com
• Welcome to Gap Inc.
• www.thefreedictionary.com
• Letter to the Shareholders 2006
• www.financial-dictionary.thefreedictionary.com
• www.planware.org/workingcapita.com
• http://www.vainteractive.com/inbusiness/editorial/finance/ibt/ratio_analys
is.html
• www.beginnersinvest.about.com
• www.investopedia.com
• www.bizwiz.com
