Gap Inc.

Equity Valuation and Analysis Valued at November 1, 2006

Brian Vance: brian.vance@ttu.edu Jonathan Applegate: jonathan.r.applegate@ttu.edu Kyle Reynolds: kingsfan0@yahoo.com Chance Baucum: chance0203@aol.com Matt Loyd: matt.loyd@ttu.edu

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Table of Contents
Executive Summary…………………………………………………6 Industry Overview and Analysis…………………………………8 Company Overview………………………………………………….8 Competitive Advantage Analysis…………………………………15 Accounting Flexibility………………………………………………..23 Accounting Strategy Evaluation…………………………………..24
Quality of disclosure…………………………………………………………………………………..25 Potential “Red flags”………………………………………………………………………………...26

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Ratio Analysis and Forecast Financials…………………………28 Liquidity Analysis……………………………………………………..29 Profitability Analysis…………………………………………………30 Capital Structure Analysis………………………………………….31 Benchmark Analysis………………………………………………....31
Liquidity…………………………………………………………………………………………………...32 Profitability ………………………………………………………………………………………………35 Capital structure………………………………………………………………………………………..38

Financial Statement Forecasting…………………………………39

Valuation Analysis……………………………………………………42
Method of comparables Valuation…………………………………………………………….43 Cost of Capital Estimation………………………………………………………………………..44

Summary of Valuations…………………………………………….45 Altman’s Z-Score……………………………………………………..49 References…………………………………………………………….51 Appendices…………………………………………………………….52

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56 Total Return% Stock +/.5 Industry 22.18 0.9 -5.53B 15.64 AEG Model RI Model FCF DPS Beta Stnd Dev. 97 797 1.95% 17.00M 1.6 YTD 8. 2005) Actual Price 20.230 $0.65 Earnings Per Share: 2005 0.21.74 2006e 0.8 23. Yld GPS ROE P/E P/B LT D/E 16.97 2007e 1.GAP INC.9 2004 -8.10% (NYSE:GPS) 20.7 -18.6 2005 -15.Industry +/. Ticker Symbol: S&P 500 Price 52 week range Market Cap Sales $Mil SHS OS Div.7 -17.6 -34.1 Valuations (As of Nov.91 . 1st.4 -4 4 .837 822.77% 3% 0.S&P 500 2003 50.3 0.80% 4.50% 0.8 15.86 0.6 -42.30% 2004 0.50% 20.39 15.

due to manufacturers competing for business. their disclosure and reporting of relevant material is seemingly very transparent. However.Executive Summary Recommendation: Overvalued firm Through detailed research and valuation. we have concluded that we are a selling opportunity. which results in the firms not having to have a price war. They also outline all accounting statements and opinions affecting their business. most of the competitors within this industry tend to rely on their brand image. The industry is characterized by emphasizing differentiation and not cost leadership. This large number of competitors creates strong earnings potential compared to other industries. We found no distortions or discrepancies in their accounting. The threat of new competitors is relatively low due to the high start up costs of entering the market. 5 . After analysis. Since Gap Inc. The biggest firms within the industry also tend to create subsidiaries in order to compete with rival firms. Gap discloses all accounting methods concerning everything from leases and pension plans to inventory and tax methods. Along with differentiation. and other firms in this industry tend to have a high quality brand image. The clothing retail industry is very competitive with a high number of competitors. most firms have power over their suppliers. Gap’s accounting practices and policies were found to be fairly aggressive.

we have found that Gap Inc.72 while our actual price per share was $17. The discounted dividends valuation model is flawed because it values companies based on what they pay per dividend. All of our valuation models showed Gap Inc. we felt we were able to grasp Gap’s overall performance as compared to its competitors within the industry. It was extremely important that our forecasts be calculated as accurately as possible due to the fact that forecasting was the base upon which all valuation methods rested. The only model which we considered to be unreliable was the discounted dividend valuation. is overvalued in the market. we forecasted the company’s financial statements through 2015. Using our free cash flow model. in-depth 6 . we found an estimated price per share at the end of 2005 to be $15. We feel this was due to our low dividend payout rate in forecasted years. After thorough evaluation. we have concluded that Gap will continue to grow at a current rate. much like the firm has been doing the last 3 years without any unforeseen abnormalities. and many companies pay little or no dividends at all.’s stock to be considerably overvalued.. By analyzing trends. To understand what the future holds for Gap Inc.After computing our firm’s core ratios. The most accurate valuation model for us was the free cash flows valuation. This is most likely due to the fact that most firms in our industry compete with differentiation and brand name. Inventory turnover tended to be lower while gross profit was high throughout the industry. Based on this all-inclusive.64.

Price.543 $17. and their direct competitors. Business and Industry Analysis Firm Overview Gap Inc. ages 18-35. They specialize in apparel design while offering clothing and accessories for the whole family.222 Price Gap Inc. Gap. They all aim to design their clothing around the younger crowds. As far as what the company does. casual designs of shirts and jeans while providing value to the shareholders and making a positive impact in the community.000 stores and is reported to have accumulated $16 billion in fiscal year 2005.789.” Abercrombie and Fitch.000 $1. Sales.821. and Buckle are some of Gap’s competitors within the industry. Old Navy.343.37 2005 $10. we find Gap Inc.com says. American Eagle. Gap Inc.347.000 $374. is one of the largest specialty retailers while leading the world in specialty retail clothing. and London.96 7 . owns more than 3.383.analysis and valuation.64 2006 $8. Their main headquarters is located in the San Francisco Bay Area but their product design offices are located in New York City. and Net Income for Gap Inc.00 $1. San Francisco. owns Banana Republic. $10.000 $405.000 Buckle $356. “We try to put out affordable. to be overvalued and strongly recommend selling. 2004 Total Assets GAP Inc. and Forth & Towne.000 Abercrombie&Fitch $1.266 $18.048. Gap Inc. Here is a table showing the Total Assets. $21.

40 $45.000 Abercrombie&Fitch $1.000 $16. investors can develop a broad and sophisticated analysis of competitive position which can be used when creating strategy.937 $501.820 $470. Gap aims to sell to the whole family with a cost-leading attitude. Rivalry Among Existing Firms 8 .267.000 Buckle $422.000 Abercrombie&Fitch $204.376 $333.000 $16. and buyers within an industry.000 $2. They have owned from 8 to 10 million in assets over the past five years.023.150. has separated itself from its competitors in the industry by claiming a huge portion of the market share. Market capitalization or net worth of the company is 14. $15. With this information. Stock is $17.Abercrombie&Fitch $47. They have more net worth than any of their competitors.000 $1. Gap Inc.021.90 $32.229 $51. $1.85 billion.25 $68.679 $43.854. It can determine the attractiveness of a particular market.91 Sales Gap Inc. suppliers.00 Buckle $29. It can also show the relationship between competitors. This can be seen by the huge Net Income compared to industry competitors.92 per share.000 $2. Five Forces Model The five forces model can help a company in a number of ways.15 $65. The current price of Gap Inc.113.830 $216.101 Net Income Gap Inc.784.986 Buckle $33.030.707. plans. or investing decisions to use within the business world.000 $1.906 As you can see in the table above.

switching costs. Old Navy. industry size and trends. The clothing stores industry. which has done extremely well over the last 5-10 years. has a large number of competitors. A few of the competing companies include American Eagle. TJ Maxx competes solely on price. In response. and differentiation and strategy. This large number of competitors creates strong earnings potential compared to other industries. created such higher end clothing lines as Banana Republic.Some aspects of rivalry among firms that make this model so important would be the number and size of firms. In the clothing store industry there is room to grow. but start up costs can be high. brand equity. Threat of New Entrants Some important factors surrounding the threat of new entrants section of the five forces model include: barriers to entry. and TJ Maxx. In an industry where the right mix of product differentiation and price play a key role. Gap Inc. While Gap is definitely looking to gain a larger share of the market. and Forth & Towne. access to distribution and government policies. To compete with all these different competitors in the market. Abercrombie & Fitch. The popularity of the internet has brought more sales opportunities for all companies within this 9 . Understanding these concepts will help a firm understand the industry at a higher level. these three brands allow them to be competitive. switching costs for consumers is low. This is especially true with one of Gap’s top competitors TJ Maxx. product/service range. Gap is looking to reestablish a larger core of consumers who are brand loyalists.

This is largely due to large economies of scale in this industry in which new entrants will initially suffer from a cost disadvantage from existing firms such as GAP Inc. These industries differ slightly because these fashion companies sell their clothing to department stores like Dillard’s. buyer switching cost. within their own industry. Tommy Hilfiger. the threat of new entrants is relatively low. They compete with these companies because switching costs are so low. and Lacoste. they also have a number of competitors in the fashion industry which includes brands such as Polo. Understanding this section will allow a firm to know how to handle any substitute products that is thrown at them by competitors. has increased the development of online marketing. In conclusion. and perceived level of product differentiation. However.industry. While Gap and its competitors compete in the clothing store industry. operates their own stores. start up costs can be high. but it will be extremely hard and expensive to match Gap’s share in the market. The risk of investing so much to start up deters most new entrants. This is the main reason they are trying to reestablish a larger group of brand loyalists with their “back to basics” simplistic 10 . Threat of Substitute Products Some key concepts that go along with the threat of substitute products are buyer propensity to substitute. Even though there is room to grow within the industry. while Gap Inc. The threat of substitute products for Gap is very real. which in turn. relative price performance of substitutes. there will always be the threat of new entrants.

can overcome this problem is with their other brands. and Buckle. Price sensitivity plays a small role but the majority of buyers are willing to pay for Gap’s moderately priced clothing. which lessens the threat of substitute products. In an industry as diverse as the clothing industry.’s prices are lower than both Abercrombie & Fitch. Old Navy offers trendier styles with a lower cost. but customers generally know what to expect with regard to prices in the industry.style that consumers had known and loved. This is where Old Navy is able to tap into the industry. an online shop. This is why having more than one line of clothing. Bargaining Power of Buyers/Customers Understanding the bargaining power of your customers will help a firm decide on the price it wants to sell its products for. consumers who are not brand loyal tend to seek out substitute products largely because of high prices. on average. On the average. this section is not as important as others in the five forces model. and sales in more than just the United States is so important. However. especially Old Navy. not a price competitive industry. Gap Inc. buyers do have some power. but Old Navy was created to appease the price shoppers. The Gap brand or Banana Republic may lose a few customers due to prices. Brand loyalists will generally buy a particular brand regardless of the price. In this market. Simply due to the low switching costs of the industry. Another way Gap Inc. every move you make determines when and how many substitute products could possibly enter your market. Sales at retail locations tend to attract customers with less spending power. Since our industry is. 11 .

Payless.. There are numerous suppliers of fabrics and other materials like cotton to choose from. must be up to date. An example of an industry that would have high bargaining power of customers would be lower quality outlets such as Kmart. the customers do not have much bargaining power within this industry. excess cost and high inventory can occur. there is an extremely high degree of competition within this clothing retail industry. Abercrombie & Fitch launched Abercrombie Kids. quarterly changes in seasonal products must happen as much as possible. for example. Branching out to places other than the United States is important. Key Success Factors 12 . Hollister Co. Most firms actually shop for manufacturers of clothes and hand their designs over to them. and Wal-Mart. Since these brands rely on the latest fashions. In conclusion. Overall. most have real power over their suppliers. Technology. This is why. and the industry in general. due to manufacturer’s vying for their business.it is important to compete on both quality and brand name. If not properly calculated. as well as price. and RUEHL 925 campaigns. Bargaining Power of Suppliers Bargaining power of suppliers is an extremely important aspect of our firm. In conclusion. including online shopping. Since the firms in our industry have a high quality brand image. these firms are relying on brand image and differentiation to gain as much market share as possible.

It can either choose a cost leadership plan or a differentiation plan.. is no different. This means that consumers might be willing to pay a higher price for the differentiating factor(s). differentiation can be defined as improving the quality of goods over time due to innovation. A cost leader can offer the same product as a competitor. These plans are important because a firm can gain an advantage over its competitors based on either of these strategies. The objective of product differentiation is to develop a position that potential customers will understand to be unique. when it first starts. only at a lower price. differentiation should reduce directness of competition. how it wants to position itself in the industry. First. This can be defined by stating that the more your product differs from the industry’s products. Gap had to make the decision of how it wanted to gain a competitive advantage over other firms in its field. Our firm. Second. Gap Inc. In an evolutionary sense. There are two mechanisms for which differentiation affects performance. It is also important that a firm choose one or the other and not get stuck in the middle. There are two strategies a firm can follow.Every firm in America has to decide. Differentiation on the other hand is competing by offering a product that is different in some way. At the market level. differentiation is 13 . categorization becomes more difficult thus your product draws fewer comparisons to competition. Cost leadership is essentially just competing with other firms only on cost. differentiation will reduce price sensitivity. Not taking one side or the other can cause a firm to earn low profits.

Not only does this new technology allow for more cost effective distribution. clothing retail industry. giving the customer a larger selection of sizes and styles. These measures taken to provide technological advantages over other companies will pay off. while producing comfortable and casual styles of dress.more of a strategy that is important in adapting to a moving environment and its social groups. but it also offers a more time-efficient experience for both the consumer and the employee. ever changing. If there is a situation where merchandise is out of stock at a particular location. Since almost all the firms in our industry have name recognition. success in this market must be achieved by adapting to a moving environment that is obsessed with the latest trends. The Gap is implementing technology into its stores which contain certain intrinsic competitive advantages which give the corporation a head up on the competition. by communicating with other GAP stores to replenish the missing units. it can be dealt with quickly and effectively. simply because it is a more convenient way of shopping. It literally bridges inventories from multiple stores in a region. Instead of spending large amounts of money yearly by manually taking inventory. The GAP will now be able to access inventory data quickly and easily through a handheld device. Competitive Analysis Gap Inc. This allows for customers to try 14 . is in the highly competitive.

GAP launched a new campaign to start 15 . Paris. Investment in brand image has had a huge impact on GAP Inc. These new ways of business improves The GAP with an entirely different shopping experience. This experience in time will increase customer retention and rapport. Around 2000.” That phrase has been the philosophy that has driven GAP for the last three decades. then people will be drawn to the unique shopping experience. The Gap Web advancements will provide the base for more company expansion. If the GAP can hold their customer base through outstanding customer satisfaction. has chosen a differentiation strategy. Gap Inc. the merchants and designers work extremely close together to translate this inspiration into reality. For around thirty years. Here. This process of creativity and innovation is very much necessary to differentiate The Gap’s clothing line from such top competitors as Abercrombie & Fitch and American Eagle. Milan. “Know who you are and be it. not just teens and young adults in their twenties. London. generating profits. as well as offer the large inventory the internet has been able to offer for many years. the designers partake in fashion shows and get a feeling for what the target audience’s preferences are. Gap’s purpose has been to appeal to people of all ages. This process starts with Gap designers who travel to such fashion and cultural capitals as New York. Once these concepts have been developed.on clothing at the store. GAP specialized in basic clothing and had a consistent core group of customers. and Tokyo. Celebrate your uniqueness with passion and conviction.

making a newer. all customer feedback. This process continues until the season ends. the company lost a sufficient amount of money.. basic. Gap’s brand image tries to differentiate itself from competitors by offering very high quality. T-shirts. 16 . As far as differentiation goes. casual clothing. At GAP Inc. A bad decision. hooded sweaters. such as the one made in 2000. each item is sold and then registered for analysis by planners and distribution analysts. then CEP Millard Drexler launched a “back to basic” campaign. Around 2002. At this point. These “replenishment shipments” usually occur one to three times per week. can cripple a company. These analysts monitor weekly sales trend reports and determine which stores need to be stocked with what products. and suggested improvements are analyzed so GAP is ready to being this cycle again. trendier style of clothing. This has improved sales. and basic pants. This change alienated many of Gap’s core customers and as a result. In order to achieve and sustain competitive advantage. Differentiation companies require heavy investments in research and development. GAP is just now recovering and it has been a slow process. Essentially. performance notes. This campaign consisted of going back to Gap’s roots and specializing in items such as denim. GAP also created flashy commercials that included choreographed dance numbers and singing. but it has been an uphill battle. Gap’s investment in brand image is by far the most important aspect of value chain management.

they learned to create their own image and not rely on celebrity status. highly lucrative. Fourth. or any of its subsidiaries. The Gap’s commitment to customer satisfaction and ability to reinvent themselves in the volatile fashion industry provides for an expected strong future for the company. to a worldwide corporation. 17 . when creating marketing campaigns. they have learned how to create their own image. basic. The Gap has learned to create sub-brands to tailor to various classifications of people. market share. Third. casual clothing. Population groups like the baby boomers are not tailored to by Gap Inc. First. would open up a whole new. but specific. Even with The Gap implementing a polished product differentiation strategy. It adheres strictly to high quality. The company has learned many lessons. Expansion of Gap Inc. with strong focus on brand development and unique advertisement. it is still not at the top of the market. they have experienced many peaks and valleys. The Gap realizes that they operate within a niche where customers care about fashion but only so long as it can be delivered at a moderate price.GAP Inc. The Gap has also learned early that they have to outsource labor in order to keep costs down and remain competitive. Second. Although The Gap has gone from being a corner shop in California. needs to stick to its roots and structure its supply chain in a way that is consistent. Their image is broad.

Balance sheet accounts are translated at exchange rates in effect at the balance sheet date. Income statement accounts are translated at average exchange rates during the year. The financial statements are consolidated to include the accounts of the company and all its subsidiaries.Accounting Analysis In the section we analyzed Gap Inc. 18 . Finally. dollars. and evaluating the accounting strategy. has disclosed all of its material very well. All inter-company transactions and balances have been eliminated.’s accounting quality by six steps. First. and point out any potential “red flags”.’s financial results. and we feel that their accounting practices are not misleading or distorted based off of the ratio analyzes of Gap Inc. Then. based on this analyzes. we felt that there was no accounting distortions to undo. Translation adjustments result from translating foreign subsidiaries’ financial statements into U. we had to evaluate how easy or less easy managers made it analyst to look at it’s financial statements. Assess Accounting Flexibility for the firm. Key Accounting Policies The Gap’s key success factors are attributed to their strict accounting polices which coordinate with each other to create the present and future financial performance of the company.S. by identifying the key accounting policies that are used. Gap Inc. The resulting translation adjustments are included in accumulated other comprehensive earnings in the Consolidated Statements of Shareholders’ Equity (Gap 10-K). Next.

(“SAB”) 101. Checks outstanding are classified in accounts payable on the Consolidated Balance Sheets. The last three years have consisted of 52 weeks while fiscal 2006 will consist of 53 weeks. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the related assets. highly liquid investments with original maturities of three months or less. The point at which the customer receives and pays for the merchandise is when the revenue is accounted for by means of either cash or credit card. Cash and equivalents are accumulated by finding all accounts in-transit from banks for customer credit card. Cash and equivalents represent cash and short-term. Amounts related to shipping and handling that are billed to customers are reflected in net sales and the related costs are shown in cost of goods sold and occupancy expenses. Property and equipment are stated at cost. Revenue and the related cost of goods sold (including shipping costs) is recognized at the time the products are received by the customers in compliance with the rules of Staff Accounting Bulletin No. The Gap uses the historical return gross profit patterns to record its allowances for estimated returns. debit card and electronic transfer transactions that go through or clear in less than a week. which are then classified as cash and equivalents in the Consolidated Balance Sheets. ends on the Saturday closest to January 31. The restricted cash account serves as collateral for the insurance obligations and recently in 2005 held $55 million (Gap 10-K). “Revenue Recognition in Financial Statements” as amended by SAB 104 (Gap 10-K). The Gap is in the retail clothing sales industry where transactions are processed very rapidly and easily. explaining their non-reporting of Accounts Receivable. The cost of assets sold or rendered useless and the 19 .Fiscal year for Gap Inc.

which can be exercised under specific conditions. Gap inc. recognizes the related rental expense on a straight-line basis and records the difference between the recognized rental expense and amounts payable under the leases as deferred rent liability. subject to terms agreed to at lease birth. As stated in the initial terms of the lease. insurance and taxes to which the Company is obligated are excluded from minimum lease payments. Most store leases are for a five year base period and include options that allow Gap to extend the lease term beyond the initial base period. 2005.accumulated depreciation or amortization are removed from the accounts with any records of gain or loss shown in net earnings. (“SFAS”) 133. 20 . Some leases also include early termination options. Future payments for maintenance. These operating leases expire at various dates through 2033. “Accounting for Derivative Instruments and Hedging Activities. 2006 and $361 million at January 29. Gap measures all derivative instruments at fair value and distinguishes them as either other current assets or accrued expenses and additional current liabilities in their Consolidated Balance Sheets. leases most of their store premises and some headquarter facilities and distribution centers. the minimal lease payment has no dependency on factors such as future sales volume and contingent rentals.” establishes the accounting and reporting principles for hedging activities and derivative instruments (Gap 10-K). Merchandise inventory is calculated using the first-in. Gap inc. The Statement of Financial Accounting Standards No. Deferred rent liability was approximately $342 million at January 28. first-out method (“FIFO”) to determine cost. By means of the cost method the inventory is valued at the lower of the actual cost or market. They also estimate and accrue shortage for the period between the last physical inventory count and the balance sheet date.

Gap does not match any contributions under this plan. Established on January 1. general liability. However under this new plan the employee members on the Board of Directors will have their contributions matched under a predetermined formula. Another pension plan of Gap is known as the (“Plan”). has acquired three different pension plans for its employees. the asset and liability concerning the Plan was approximately $24 million and $30 million. respectively. 21 . This plan allows employees to make contributions up to a maximum limit and Gap matches the contribution total amount or a portion of it according to a predetermined formula. In January of 2006 a nonqualified Supplemental Deferred Compensation Plan replaced the (“Plan”).This new nonqualified Supplemental Deferred Compensation Plan now allows for employees and non-employees on the Board of Directors to defer compensation up to a limit.Gap Inc. 1999. Gaps’ contributions to this plan averaged $30 million over the last three years. Accrued expenses and other current liabilities consist of payroll and related benefits. all with different types of defined benefit or defined contribution plans. They use a combination of insurance and self-insurance for a number of risk management activities including workers’ compensation. It allows eligible employees to defer compensation up to a maximum amount. some of which is paid by their employees (GPS 2005 Annual Report). As of December 31. deferred rent liability and other current liabilities. This is a nonqualified executive deferred compensation plan.” is a qualified defined contribution plan. “GapShare. 2005 the plan was frozen for additional contributions. The First. available to employees who meet certain age and service requirements. automobile liability and employee-related health care benefits.

Income taxes are recorded using the asset and liability method in compliance with SFAS 109 “Accounting for Income Taxes” (Gap 10-K). Deferred income taxes come from temporary differences between the tax part of assets plus the liabilities under this method. The reported amounts from the calculations are then shown in the Consolidated Financial Statements. Accounting Flexibility Gap Inc has a significant amount of flexibility in choosing their key accounting policies. Gap Inc. prepares financial statements in accordance with accounting principles commonly accepted in the United States of America. Management is required to use accounting policies in order to make significant judgments and estimates to develop amounts reflected and disclosed in the financial statements. Gap Inc. has shown accounting flexibility in many areas on the financial statements. Merchandise Inventory is valued using the cost method. Cost method values inventory at the lower of the actual cost or market. Gap Inc. determines cost using FIFO method, and the market cost is estimated by the net realizable value. Also, depreciation and amortization are calculated using straight-line method. Cost of assets sold or retired and related accumulated depreciation or amortization are removed from the accounts with any resulting gain or loss included in net earnings. Under Financial Accounting Standards No.133, “Accounting Instruments and Hedging Activities”, establishes the accounting and reporting standards for derivative instruments and hedging activities. Gap Inc. recognizes all derivatives instruments as either other current assets or accrued expenses and other current liabilities in Gap’s Consolidated Balance Sheets and measures those instruments at fair value.

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Gap Inc.’s accounting reports seem to have a lot of flexibility for managers.

Accounting Strategy Evaluation Gap’s preparation of financial statements is in conformity with accounting principles generally accepted in the U.S. Managements is responsible to make estimates and assumptions that affect the reported amounts of assets and liabilities. Gap Inc. reports any accounting methods they use or any areas in their consolidated statements that might seem unclear to investors in the footnotes. For example, during the fiscal year of 2005, Gap Inc. accounted for stock-based awards to employees and directors using the intrinsic value method of accounting required by APM, Accounting Principles Board Opinion. Under this method when price of employee stock options equals the market price of the stock on the day it was issued, no compensation expense is recognized in the Consolidated Statements of Operations. Stock options that are less than fair market value are amortized to operating expenses over the vesting period of the stock award, using the straight-line method. In the clothing retail industry, they all record Gift cards at different times. For example, American Eagle, one of Gap Inc.’s competitors, records a gift card as a current liability upon purchase and recognized when the gift card is redeemed for merchandise. AE gives customers 24 months to redeem the gift card or the Company assesses the holder of the card a one dollar per month service fee, which is deducted from the value of the gift card. The fee is recorded in selling, general and administrative expenses. Unlike Gap Inc., who treats gift certificates or gift cards as a liability and income is recorded as net sales upon redemption or as other income, but up to sixty months. After sixty

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months is up, the redemption is remote, and the liability for gift cards and gift certificates is recorded in accounts payable on the consolidated balance sheets. Quality of Disclosure throughout Financial Statements Every manager in a firm has the discretion to disclose information. Accounting rules require a certain amount of disclosure, but beyond that it is up to the manager how much information the firm will disclose. Quality of disclosure is very important to an investor. A manager can make it easy for an analyst to gain an insight into the firm by disclosing a lot of information. On the other hand they can make it quite difficult to assess the business reality by only disclosing the minimum amount required. As an investor you want as much disclosure as possible without threatening the firm’s competitive advantage. If you disclose too much information the competitors will be able to look through the glass and see your strengths and weaknesses, of which they can then turn around and use against you or copy your strengths and gain a profit like yours. GAP does a good job of disclosing its’ business strategy. In the Letter to Shareholders they do not try to sugar coat their performance. They are quite liberal in disclosing bad news. Paul Pressler, CEO of GAP, makes no attempt to explain the drop in Net Sales for 2005. Instead of excuses he clearly lays out a plan to return to growing sales and to regain Gap Inc.’s competitive position. One criticism of disclosure is that there is no real explanation of Gap Inc.’s performance from 2005. Their net sales were down 2% from 2004. Gap Inc. did not try to explain this decrease to any reason. They basically just said they can do better and have a plan in place to return to its’ increased earnings. Another good quality of Gap Inc.’s disclosure is that they break up their finances by different companies. Gap Inc. owns Banana Republic, Old Navy, and Forth and Towne. In their annual report they separate these businesses out so 24

goes above and beyond disclosure for their cash flows to show the analyst how important they feel these cash flows are. is also very good with disclosing numbers that they think are important. we were unable to find any flags in GAP Inc.all their performances aren’t lumped together. This level of disclosure makes it very easy to determine the reality of Gap Inc. Even when performance was down. They also explain in their footnotes all the forward looking statements that they include in their annual report. After 25 .’s report they use numbers and strategies with forward looking statements that basically anticipate future effects on cash flows. There were no unexplained transactions to boost profits. which makes it easier for the analyst to determine if these numbers are accurate. does a great job of disclosing information for an analyst or investor. They believe that free cash flow is important because it represents how much cash a company has after the deduction of capital expenditures. Gap Inc. there were no unexplained changes in the accounting process. In Gap Inc. and new store openings. Gap Inc. Inventories did not increase in relation to an increase in sales. dividend payouts. cash balances vs. Gap Inc.’s position in the industry and to forecast future financial results Identification of Potential “ Red Flags” As far as identifying red flags. There were no large fourth-quarter adjustments. Free cash flow is a subject they spend a lot of time on in their financial report. cash flows. This can show the investor or analyst which companies are doing well and which aren’t.’s financials statements. There were no unusual increases in accounts receivable with respect to sales increases. In conclusion. They explain how they came to these numbers.

Quantitative Indicators When you study the quantitative indicators you can then effectively analyze the past performance of Gap inc.04 N/A 2005 10. meaning they have been getting less cash from sales.34 N/A 2004 10. 26 .05 9. The sales manipulation diagnostics shows how sales relate to cash from sales.3 8. However. their Net Sales/ Cash from Sales ratio has declined a little.33 N/A 8. Net sales to accounts receivables were N/A due to the fact that the accounts receivable amounts for Gap Inc. Sales Manipulation Diagnostics GPS Net Sales/ Cash from Sales Net Sales/ Net Accounts Receivable Net Sales/ Inventory 2001 10. Gap’s ratio of sales to inventory has increased from 2001 and 2002. This shows that GAP has been making more profits while spending less on inventory.analysis.’s accounting is legitimate with no questionable accounting quality.51 N/A 2002 11.45 Sales for Gap have been steady over the last few years. accounts receivable. The core expense manipulation diagnostics shows earnings related to expenses. were reported as immaterial. and inventory. GAP Inc.97 9. This is a good sign for the future of the firm.63 N/A 2003 7.26 7.

69 Gap’s asset turnover ratio shows that for every $1 of assets. Ratio Analysis & Forecast Financial In the next step of evaluating Gap Inc.82 in sales.82 0. We will attempt to forecast the financial statements of the company for the next ten years. If the CFFO/OI number is smaller.36 2004 1. GAP made $1. profitability. GAP has increased its asset turnover after down years of 2002 and 2003.78 0. CFFO/NOA starts off relatively high.82 3. Financial Ratio Analysis 27 .89 0.46 1. liquidity. and finally levels off starting in 2004. This could prove to be very valuable to investors in the company.16 0..65 2002 1.48 1.45 2003 1.Core Expense Manipulation Diagnostics GPS Asset Turnover (Sales/Assets) CFFO/ OI CFFO/ NOA 2001 1. By doing calculating financial ratios we able to get a more in depth look into the companies. We will compare Gap Inc.22 0. more of the Cash Flow from Operations can be explained by Operating Income. with the industry average as a whole in ratio analysis.62 0. then dips for a couple years.1 0. and capital structure. This shows that they are more efficiently using their assets CFFO/OI for the most part remains steady aside from a decrease in 2002.76 2005 1. we have calculated financial ratios to measure the performance of the company. The two years in which this figure is low can be explained by GAP using more of their Operating Assets to bring about their Operating Cash Flow.

48 0.69 2.146 4.10% 26.95 12.5 153.2 4. Then.In order to analyze financial statements of a company we have to calculate different ratio.11 1. we analyze the capital structure of a company.6842 1.30% 0.79 63 14 2002 30% 27.45 67 4 2005 39.146 0.79 1.29 1.612 5.46 2003 4.48 1.97% 1.61% 1.50% -5.02 N/A 2005 11.66 2002 3. Liquidity Analysis Current ratio Quick asset ratio Accounts recevable turnover Days supply of inventory Inventory turnover Days supply of receivables Working capital turnover 2001 0.06% 1.16 2005 2.4 7.66 78 4.62 11.95 3.80% 13% 1. First.75 -90.82 -0.10% -0. we analyze profitability ratios.77 2004 37. and how much of that profit goes to the shareholders.03 Profitability Analysis Gross profit margin Operating expense ratio Net profit margin Asset turnover Return on Assets Return on equity Debt to equity ratio Capital Structure Analysis Times interest earned Debt service margin 2001 19.09 31.5 5. which determine where and how much financing for a company is provided.22 2003 2.22% 26.146 113.07 N/A 2004 8. We have calculated the financial ratios of Gap Inc.82 242. These ratios can help determine where the cash comes from and where it goes. Ratio analysis can also provide us with background in figuring out future performances.49% 1.856 N/A 28 .95% 21.53 9.7 2004 2.496 2001 37.63 2.44% 23.26% 15.5% 6.8 63 3.79 2003 34% 27% 3.40% 1. With this analysis we can predict future profitability for the company and its shareholders.51% 29.50% 1.39 2002 1.79% 6. which determine the quick cash from assets and the ability of a firm to turn assets into cash to meets its debt. over the last five year and compared them to three of our top competitors in the industry. we analyze the liquidity ratios. which tell us how much profit is earned from our sales and assets.52 80.29% 1.88 226. Financial Ratio Analysis is split into three parts. Finally.24 125.8 1.9 4.64% 25.38 5.

79 67 5.82 242. Account receivables have decreased and could be the cause for the reduction in the number of days receivables are collected. Gap Inc. which means they have more quick cash on hand to pay for every liability they owe.79 2.9 4. 29 .6842 1.66 2.146 0. has shown more money coming out of the production cycle due to the increase in inventory turnover. Gap Inc.63 63 5. Working capital has improved a little but recently has fallen. Cost of goods sold has also increased. which means less expense for the company.24 125. Inventory turnover has improved as well and fewer inventories are hanging around.5) 2002 1.45 1.’s account receivables turnover has increased over five year.79 2004 2. Gap Inc.146 113.48 0.5 4 Current ratio Quick asset ratio Accounts receivables turnover Days supply of receivables Inventory turnover Days supply of inventory Working capital turnover From 2001 to 2005. Gap Inc. has continued to improve though and overall they appear to be more liquid and operating efficient over the last five years.2 (90. which is allowing them to pay off more of their liabilities.77 2005 2. In 2001 they had more liabilities than asset.48 63 5. which is reducing the number of days accounts are collected. Over the last five years. making the ratio negative for working capital.69 78 4.’s current ratio has risen. which can be the cause for the increase in Inventory turnover.38 14 2003 2.52 3.612 3. Their quick asset ratio has also risen.Liquidity Analysis 2001 0.75 4.95 80.8 1. A negative working capital implies that they could not pay for all their liabilities from sales and assets.5 153. Their current assets have increased over the last five years.8 1.11 1.88 226.

On the other hand. they suffered a profit loss. Once again.40% 1. which measure sales against assets.61% 1. Gap Inc.Profitability Analysis 2001 37. which measures net income against assets.99% 4.49% 1.82 -0. In 2002.28% 2002 30.00% 27.95% 21. Gap Inc. when they suffered a loss on net income. Gap Inc. has kept constant on earning from assets compared to sales.68% 2004 37.22% 26. To do this we have to look at gross profit margin.50% 21. has been pretty profitable for shareholders over the years. Finally we looked at how much profit shareholders received. and they seem to constant on operating efficiency.30% 0.29% 23. Next we look at how much Gap Inc. and return on assets. Gap Inc. operating expense ratio.29% 4.10% -0. they have managed expenses well the last five years and made substantial profit.10% 26. Overall. Gap Inc. by calculating return on equity. In 2002.80% 13% 13% 9.50% -5. suffered a loss in net income.62 11. which caused them to have a negative return on assets.95 12. Although.53 9.146 4.61% 2005 39.38% 2003 34% 27% 3. has made constant profits over the years. except in 2002.96% 1. because they acquired more assets over the year.51% 29.64% 25.06% 1. made on their assets.26% -26.’s overall profit efficiency has stayed constant through the years.44% 23.49% Gross profit margin Operating expense ratio Net profit margin Asset turnover Return on Assets Return on equity SGR Sales Growth Operating efficiency is what we will measure next. To measure this we look at asset turnover.4 7.50% 2. from sales and net income. and net profit margin. due to an increase in cost of goods sold and operating expenses.97% 29.79% 6.5% 6. They had their lowest turnover in 2003. Capital Structure Analysis 30 . their return on assets has fluctuated the past five years.

7 4. which measures how much cash from operations was paid to service debt. except in 2002. has been able to pay off their debt the past five years and shows to be very creditworthy.22 3.50% 2005 23.46 2003 1.29% The sustainable growth rate measures how much a firm can grow without its financial policies unchanged. Sustainable Growth Rate 2001 29. Overall Gap Inc. In those two years they show a high debt service margin.99% 2003 13% 2004 21.856 N/A The last ratio we looked at was the capital structure for Gap Inc.66 2002 15.29 1. and debt service margin. except in 2002. Finally we calculated debt service margin. Capital structure analyzes the financing of a company.39 19. where they had more interest expense that year.03 11.96% 2002 -26. A firm’s return on equity and its dividend payout policy help determine the funds for growth. has continued to grow the last five 31 .’s debt to equity ratio has been pretty low.02 N/A 2005 1. To do this we calculate three ratios. times interest earned.07 N/A 2004 1.Capital Structure Analysis Debt to equity ratio Times interest earned Debt service margin 2001 1.09 31. which measures how much income comes from operations to pay for interest charges. and the higher the ratio the more creditworthy a company is. Gap Inc. has listed notes payable only for two years. where they had a lot more debt than equity. Gap Inc. Gap Inc. This is a way to put all the ratios together and measure them. which are debt to equity. Companies usually like to keep a ratio between four and twelve. Next we measure times interest earned ratio.16 8. The higher this ratio is the less pressure to use operating cash flows for debt. Gap Inc. has had a pretty high times interest earned ratio the past five years.

5 0 2001 2002 2003 Years 2004 2005 Gap Inc.5 0 2001 2002 2003 Years 2004 2005 Gap Inc. Quick asset ratio 2.’s quick asset ratio has increased more than the industry average.5 1 0.’s current ratio has been increasing the past five years and appears to have risen above the industry average in 2005.years.5 2 1. American Eagle ANF Industry Avg. Gap Inc. American Eagle ANF Industry Avg. They have been able to pay for the liabilities with quick cash on hand more than any of their competitors. Benchmark Analysis Liquidity Current ratio 3. which caused them to not grow.5 1 0.5 2 Total 1. Overall they have kept a constant growth rate around 20 % each year. They suffered a loss in 2002. Gap Inc.5 3 2. Over the years their current assets have increased more than any of their competitors. Total 32 .

33 . More money is coming from those accounts receivables in less days. They have received more accounts receivables than anyone in the industry. They appear to be able to turn more account receivables over then anyone in their industry. American Eagle ANF Indust ry Avg Gap Inc. Days supply of receivables 35 30 25 20 15 10 5 0 2001 200 200 Y ear s 200 2005 Gap Inc. Americ an Eagle ANF Industry Avg. has decreased in the number of days it takes to turnover those accounts receivables into money.Acct. Receivables Turnover 300 250 200 150 100 50 0 2001 2002 2003 Y e a rs 2004 2005 Gap Inc .

Working capital turnover 60 40 20 0 -20 -40 -60 -80 -1 00 Y e a rs 2001 2002 2003 2004 2005 Gap Inc. American Eagle ANF Industry Avg 34 .Inventory turnover 30 25 20 15 10 5 0 2001 2002 2003 Years 2004 2005 Gap Inc. This is due to a decrease in Sales over the years. Total Days supply of inventory 100 80 Days 60 40 20 0 2001 2002 2003 Years 2004 2005 Gap Inc. appears of turnover less inventory than their competitors. American Eagle ANF Industry Avg Gap Inc. has not been able to turn its inventory over so quickly. The industry appears to be able to turn their inventory over faster. American Eagle ANF Industry Avg Gap Inc.

They have always been below the industry average the past five years . 35 .00% 20.00% 60. sales were negative.00% 2001 2002 2003 Years 2004 2005 Percentage Gap Inc.00% 30. Profitability Gross profit margin 70. In 2001. Gap’s competitors have seem to have accumulated more sales.Working capital has been very low in the past few years.00% 40. providing a negative working capital ratio.00% 10.00% 50.00% 0. American Eagle ANF Industry Avg Gap’s Gross Profit margin has always been low due to increasing cost of goods sold.

due to decreasing Net income and increasing sales.Operating exp ratio 30 25 20 15 10 5 0 2001 2002 2003 Y e a rs 2004 2005 Gap Inc American Eagle ANF Industry Avg.00% -1 0.00% 5. Operating expenses has always been low for the industry.00% Y e a rs 2002 2003 2004 2005 Gap Inc.00% 0. American Eagle ANF Industry Avg Gap has generated a lower net profit than any of its competitors. until 2004. In 2002 they reported a loss in sales. Their operating expenses seem to have increased while their sales have decreased. Gap has followed with the trend. Net profit margin 1 5.00% 1 0.00% 2001 -5. 36 .

00% 40.5 1 0.00% 20.5 0 2001 2002 2003 Years 2004 2005 Gap Inc.00% 5.00% 15.00% Percentage 30. 37 . American Eagle ANF Industry Avg 2001 2002 2003 Years 2004 2005 From this graph you can tell that gap has made less profit on assets than the industry.00% 0.00% Percentage Gap Inc.00% 0.00% -10. This will cause a decrease in total sales Return on assets 35. American Eagle ANF Industry Avg They appear to turnover less assets than their competitors. Return Equity 50. They have reported lower net income than any of their competitors.00% 10. due to lower net income Gap Inc has a lower return on equity than the industry.5 2 Total 1.00% -5.00% 25.00% 20.Asset Turnover 2. Once again.00% 10.00% 2001 2002 2003 Years 2004 2005 Gap Inc American Eagle ANF Industry Avg.00% 30.

Capital Structure Debt to equity 20 15 Total 10 5 0 2001 2002 2003 Years 2004 2005 Gap Inc. American Eagle ANF Industry Avg Gap’s Interest expense has always been higher than the industry. Gap Inc. This caused a huge reduction in net sales. American Eagle ANF Industry Avg In 2002. Times Interest earned 200 150 Total 100 50 0 2001 2002 2003 Years 2004 2005 Gap Inc. 38 . accumulated more debt than equity compared to its competitors. which causes a lower time interest earned ratio.

we are doing a financial analysis of GAP Inc. In a financial analysis you can determine the value of a firm by looking at it’s profitability and it’s growth. This allows us to see how GAP compares to other firms in the same 39 . We will be using ratio analysis and cash flow analysis to assess GAP’s performance. After analyzing GAP we will forecast the next ten years based on our findings. This graph only compares two accurate years of numbers. American Eagle ANF Industry Avg Some competitors. Financial Forecasting In this section. If we compare the ratios to other firms’ ratios we are doing a cross sectional comparison. along with Gap Inc. Looking at ratios for our firm over several years is called time series comparison.Debt service margin 35 30 25 20 15 10 5 0 2001 2002 2003 Y e a rs 2004 2005 Gap Inc. We can either look at ratios for GAP over several years to determine the success of the firm or we can compare the ratios of GAP to other firms in the same industry. These ratios allow us to relate the financial numbers to the business reality. In ratio analysis we examine our firm’s balance sheet and income statement. did not report any notes payable from 2003 to 2005. This allows us to hold some factors constant and determine the firm’s strategy and how well they are implementing this strategy. The goal of a financial analysis is to evaluate the performance of a firm by using their financial statements.

Finally after analyzing GAP’s financial statements. It is important to forecast so we can determine the future of the firm and if the firm is currently undervalued or overvalued. and sales growth. and total shareholder’s equity shows us how we are financing our firm through equity. You can average past performances of the firm and assume this past performance will continue. Balance Sheet Forecasting The accounts on the balance sheet that we feel are the most important to forecast are accounts payable. common stock. Our financial analysis and forecast of GAP should provide a clearer picture of the performance of GAP then just scanning their financial statement. total liabilities. By looking at the cash flow we can find a number of things that are important to valuing our firm. We can see if our firm has the ability to pay its interest and long term debt payments from the cash generated from operations. Sometimes this can provide inaccurate numbers. We can use a number of methods to determine our forecasting values. This lets us determine in what areas they are lacking and what areas they are excelling in compared to firms in the same industry. Accounts payable. and total liabilities show us our debt. We need a high 40 . total current liabilities. which means that over time they go back to the industry average.industry. We can also find if GAP is making a cash surplus from operations or making enough cash to invest in long term growth. In cash flow analysis we study the firm’s cash flow statements to get further insights into the firm’s policies. current liabilities. total shareholder’s equity. So values are mean-reverting. Common stock. These things can give us a better idea of the risk of our firm. Sales growth is important because it is what drives our firm. This will allow us to determine the success that GAP has had in implementing strategies and gaining profitability and growth. we can forecast the future for the firm.

accounts payable. If there are any major changes within the company. and cash and equivalents for beginning and year end. Cash Flow Forecasting The accounts used in forecasting some of Gap’s Cash Flows were net earnings. depreciation and amortization. All of the accounts were forecasted by taking the average off the common size income statement. For this account. and Net Income. net cash used for investing activities. deferred lease credits and other long term liabilities. we used the current ratio to forecast. Even with the weaknesses in our forecasting method. As always the case with forecasting these numbers could be changed by any change in GAP’s operations. the forecasts will deviate from the projections made when forecasted.( Refer to Exhibit B) Income Statement Forecasting We were able to forecast every account in our income statement. While these projections can prove to be extremely helpful. We took the averages of values off the common size balance sheet to forecast for our actual balance sheet. The majority of the values derived 41 .sales growth to continue creating value for our shareholders. net cash provided by operating activities. Net sales show us how much GAP is selling throughout its many stores. Cost of Goods Sold. we realize that these numbers may not be 100% accurate. Net income is also important because it gives us our final dollar amount that we earned for the year. net increase/ decrease in cash and equivalents. loss on disposable and other. Cost of Goods sold and operating expenses give us an overview of the cost of doing business for GAP. The only account forecasted using another method was the total current liabilities. We can analyze this and see where their costs are too high. net purchase of property and equipment. Operating Expenses. The most important ones for GAP are net sales. we feel that the methods used were the most appropriate for GAP Inc.

we need to create a sensitivity analysis which will make sure that miscalculated costs of capital and growth rates will not give us bad results. or an average of the percentage change multiplied by a corresponding number in the balance sheet or income statement. However this forecasting method is based mainly on recent information and is not always a good predictor to future performance. Just as the methods used to forecast the balance sheet. Valuation Analysis So far we have calculated the financial ratios and forecasted financial statements for the next ten years. Valuation is important because we can price an initial public offering and be able to inform parties involved with Gap Inc. In this is section we will complete prospective analysis by valuing Gap Inc. The cost of capital and equity will give us a weighted average cost of 42 . the methods used to forecast the cash flows can be helpful for figuring ballpark numbers and aid in decision making. However. through different methods. because one method alone cannot provide a sound basis for a firm valuation. In order to evaluate a company we use many different methods.upon forecasting cash flows come simply from the balance sheet and income statements. Intrinsic methods along with comparable ratios must be calculated for the firm in order to get a true picture of what the company is worth. credit and other business concerns. on their actual sales. either through subtraction of the trailing year. which was the first stage of prospective analysis. the loss on disposable and other account was derived through and average of the trailing three years for each year forecasted. Also.

0874.11 18. which are American Eagle and ANF.27 4. PEG and P/B ratios. P/E.217 2.16 8.055 BPS 6.267 P/E 17.86 21.29 2.86 1. Gap Inc. to two of its main competitors. Cost of Capital We calculated Gap Inc. which is used in many of our intrinsic valuation models.capital. by taking the average multiple of competitors in the industry.116667 P/B 3 5. The following sections will demonstrate how we use each intrinsic valuation method to value Gap Inc.16 0.09 2.98 65. They help us value a company in terms of how much equity is being provided.96 4.33 1.23 16.02 N/A 2. so it may not be the best comparison for Gap Inc. EPS 1. This is the return shareholder for Gap Inc.632667 PPS 17. and its competitors were very helpful. which is the 43 . The ratios were combinations of stock price and earnings to shares outstanding. Gap Inc. Method of Comparables This method values Gap Inc.18 35. price per share.44 Gap Inc American Eagle ANF Avg. The ratios used in this model to value Gap Inc.05499.765 9.64 22.973 13. We compared Gap Inc.592 DPS 2.’s cost of debt is .4 PEG 1.36 4. In most of the ratios Gap Inc. dividends per share. has lower Earnings per share than any of its competitors. Our averages only have two competitors in it. require. The ratios used in this valuation include: earnings per share.’s cost of equity to be . book value per share. has a low percentage than its competitors.

’s securities.12.14 and we calculated our after tax WACC to be . 44 . RSquared 3 year Beta. Variables 2 year Beta. RSquared Published Beta Cost of Equity Before Tax WACC After Tax WACC Cost of Debt 0. The R. we decided to use a five year treasury maturity rate as our annual yield.Squared will measure this from a range of 0-1.14 0.006917 0.025614 0. Gap Inc.12 0. Our before tax WACC is .05449 We needed to compare Gap Inc. Annual Yield In order to calculate the average risk free rate to get cost of equity.rate Gap Inc.91 0. This is the average expected return on Gap Inc.004444 0. Most investments are made over this period of time rather than three or six months. RSquared 5 year Beta. No correlation is 0 and perfect correlation is 1.107 0.’s R-Squared shows no correlation with the market. is paying on all of its debt.’s stock performance with a benchmark index such as S&P 500.

which is calculated by subtracting the estimated value of the firm by the liabilities. Our estimated market value of equity came out to be $ 13.64. (Refer to 1. which tells us that Gap Inc.935.710. we needed to find the estimated price per share at the end of 2005.713.34. Next.34. to find an estimated price per share at the end of 2005 to be $15. To find the value of the firm we added the present value of the annual cash flows and the present value of terminal value perpetuity.Intrinsic Valuation Methods Free Cash Flow Free cash flows will give us an estimated share price for the firm. Finally.476.92. we had to find the present value of the continuing terminal value.527. was slightly overvalued. and with no growth we found it to be $ 19. We found the value of the firm for 2005 to be $ 13. Finally. We calculated the free cash flows by adding the cash flow from operations and investing activities.569.8) 45 . divide our estimated market value of Equity by the number of outstanding shares.14.971.299.601.364.935.532.’s observed share price at the end of 2005 was 17. This model uses the WACC based on a flow of free cash flows.72. We calculated the total present value of annual free cash flows to be $ 6. Gap Inc. To do this we first needed to find the market value of equity. We discounted are WACC back to 2005.

1 15.46 15.01 0. The reason for this maybe that Gap Inc.48 The sensitivity analysis shows varying WACC and growth estimates.94 17.29 21.13 9.79 10.5 14.12 11.2 14. Using the discounted dividends method.39 0. Discounted Dividends This method of valuation uses Ke and the forecasted dividends to value the firm at a certain time. is way over-valued. Gap Inc.04 17.Sensitivity Analysis WACC 0.37 19.78 0.04 21. 46 .29 13. The higher the growth rate the higher the share price varies.17 12.4 13.67 15. because dividends have not changed.39 19.48 12.17 0 0. pays low dividends and this model only values a company by their dividends.03 0.87 17. which tells us that Gap Inc. Then. The observed price per share for Gap Inc.17 at the end of 2005.41 19.64. was slightly overvalued.64.49 15.115 12.13 21. Gap Inc. kept there dividends constant at $.42 11.59 11.63 0.27 14.105 14. we discounted back the dividends to 2005 using Ke.31 12.8 27.37 14..89 17.07 13. This is not a good model to value Gap Inc.1 23.47 19.55 0.17 13.02 0. We calculated a share value of $0.56 15.48 0.18 and used a growth rate of zero.095 G 0.95 0. Gap Inc.’s observed share price at the end of 2005 was 17.85 17.11 13.125 10. This shows that as WACC increases with zero growth the share price decreases. was $17.38 24. at end of 2005.

then subtracting the dividends per share.115 1.52 -4. Then we needed to find the normal income. and then discounted all the numbers back to the present time.14 12 -36 -12 From the sensitivity analysis you can see the growth rate cannot be very high.27 5.000 0.05 4 6. The difference between earnings per share and normal income is the residual income.060 0.095 1.14 12 -36 -7.894 3.07 2. which we did by multiplying Ke with the beginning book value of equity from the previous years.3 -5.5 -3..4 3.2 -5.3846 1.130 0.2 36 -12 -7. This model is not very accurate in valuing Gap Inc.120 0.6 -3 0.714 2.Ke g 0. Just to get to price per share. (Refer to 1.2 0. We then discounted the residual income from forecast and found present value of residual income. the growth rate would have to be than 1 %.2857 1.7) Residual Income In this model we calculated a stream of residual incomes for the next 10 years.27 5.569 24.769 4 7.105 1. present value of RI. and should not be considered in the final valuing of this company.0874 2.5 -9 -4.6 0. First we had to find the ending book value of equity which we found by adding the book value of equity with the earning per share. and present value of terminal value at the end 2005 we estimated a 47 .5714 6 18 -18 -6 -3.080 0.14 0.32 -14.565 2. including a terminal value.040 0.5 4. Adding the book value of equity.08 1.100 0.225 0.

The actual share price was $17.9) The sensitivity analysis for residual income measures Ke and growth rate.11 $2.05 $7.15 $7.1 0. If there is a high value for abnormal earnings. Abnormal earnings are expected net income minus the normalized income multiplied by the discount rate.16 $7.1 $7.14 0.33 This analysis does not have extreme changed in share price when changing the growth rate.59 $5.96 $2. On the other hand.86 $2. The stock will be overvalued or undervalued depending on whether expected earnings are more or less than normal income.64. then a firm shows negative future stock returns.48 0.58 0. is way over valued.49 $4.44 $4.29 $5. Gap Inc. 0 Ke 0. If there is a low value for abnormal earnings.12 0.97.19 $3.54 $5.16 $3. (Refer to 1. The more growth and higher Ke the lower the share price.08 0.44 $5. 48 . if our Ke increases by a lot then Gap Inc.11 $3.share price of $7. Using this model. Abnormal Earnings Growth The abnormal earnings growth valuation involves calculating the book value of equity plus the present value of expected future abnormal earnings.21 $2.01 $3.34 $4.63 0.26 $2. will have a lower share price.

81 $2.02 $4. knows how to handle their credit and there fore this lowers the interest rate they will pay on future loans.1.87 $4.05 $6. The higher the growth rate and Ke. occurs. therefore we can predict that there will be negative future stock returns.27 g 0.1) Sensitivity analysis for AEG looks at growth rate and Ke.1 0.16 $7.17 0.94 $3. Sensitivity Analysis 0 Ke 0. according to Altman's Z-score model. the less the share price.12 Altman’s Z score Banks often prefer to look at a company’s Altman Z-Score when determining credit risk before issuing a loan or starting an investment.then the complete opposite. One of the major incentives to decrease the Z-Score is to rely less on capitol leases and more upon operational leases. positive future stock returns.66 $2.61 $2.89 $3.84 $3. ( Refer to 2.56 $2.’s debt risk for the previous year.15 $6. In our case.86 $2.99 $3. This high debt risk is a good sign for investors because it shows Gap Inc.08 0. is 3.92 $4. Gap Inc. Gap Inc.12 0.14 0.71 $2.76 $2.71 $2.1 $6. GAP Inc. has a low value for AEG.97 $4.22 0. strives in this 49 .

Estimated share price 11.6(14. some of the intrinsic valuations do not resemble the valuation for the company. Free Cash Flow method comes the closest to valuing Gap Inc.4(1113/8821)+ 3..48 7.97 6. 50 . Z score: 1.97 11 17.64 Free Cash flow Residual Income Abnormal Earnings Growth LR ROI Actual Price Free Cash Flows is clearly the best method to use when valuing Gap Inc.2(5239-1942/8821)+ 1. The other methods valuate to much on dividends paid or earnings rather than cash from operations or investments.1 Summary of valuations For Gap Inc.6/3396)+ 1.3(1745/8821)+ 0.department because they use mainly operational leases for there stores and warehouses.0(16023/8821) = 3. The company appears to be way over valued by each method.

shtml 51 . 4. 2.References 1.com/public/Investors/investors.pwcglobal.morngstar.edgarscan.com www.yahoo.com www.gapinc.com www. www.finance . 3.

cost of equity Weighted Avg.4 1. cost of debt 52 .3 Ratio Forecast Balance Sheet Proforma Balance Sheet Income Statement Proforma Income Statement Cash Flows Discounted Dividends Free Cash Flows Residual Income LR ROI AEG Weighted Avg.2 2.6 1.1 2.3 1.5 1.0 2.Appendix 1.7 1.1 1.9 2.2 1.8 1.

06 2.82 242.13 5.46 2002 -26.96% 2002 1.612 5.44 Profitability Analysis Gross profit margin Operating expense ratio Net Profit Margin Asset Turnover 53 .86 62.6 5.48 0.95 3.46 2003 38% 25% 4% 1.42 2005 2.10% 26.24 125.146 113.33 5.64% 25.79% 6.05 40.06 9.22 3.08 2002 39% 25% 6% 1.4 7.79 63 14 2002 30% 27.8 1.61 72.63 2.38 5.76 2002 2.07 N/A 2003 13% 2004 2.29% Profitability Analysis Gross profit margin Operating expense ratio Net profit margin Asset turnover Return on Assets Return on equity Capital Structure Analysis Debt to equity ratio Times interest earned Debt service margin Substainable Growth Rate American Eagle Liquidity Analysis Current Ratio Quick Asset Ratio Accounts Receivable Turnover Days supply of Receivables Inventory Turnover Days supply of Inventory Working capital turnover 2001 2.39 19.51 1.50% 2005 2.66 2001 29.82 -0.1 Ratio Forecast GAP INC.02 0 2004 21.03 11.5 153.51% 29.88 226.79 1.40% 1.29% 2005 1.66 78 4.9 5.8 7.2 4.52 2004 3.45 67 4 2005 39.7 4.5% 6.77 2004 37.146 0.22% 26.23 2004 47% 24% 11% 1.50% 2004 1.73 4.06% 1.11 1.10% -0.80% 13% 2003 1.61% 1.8 101.29 1.17 5.23 4.09 31.48 1.7 2003 2.81 2001 41% 27% 8% 1. Liquidity Analysis Current ratio Quick asset ratio Accounts recevable turnover Days supply of receivables Inventory turnover Days supply of inventory Working capital turnover 2001 0.50% -5.99% 2003 2.44 1.16 79.95 12.9 4.2 2005 46% 23% 13% 1.Exhibit 1.99 2.38 49.5 5.53 9.16 8.34 1.95% 21.8 63 3.75 -90.59 7.07 3.30% 0.29 3.62 11.146 4.34 49.12 5.91 62.97% 2001 1.44% 23.7 3.49% 1.69 2.5 2001 37.6842 1.18 71.856 0 2005 23.52 80.46 5.88 62.26% 2002 15.79 2003 34% 27% 3.

395 54.15 18% 25% 2005 0. Liquidity Analysis Current ratio Quick asset ratio Accounts recevable turnover Days supply of inventory Inventory turnover Days supply of receivables Working capital turnover 2001 1.9 21.315 23.3 13.22 4.29 83.23 4.48 1.24 53.59 16.6 0 Industry Avg.4 6.77 1.1 4.4 0.69 11.78% 2.94 0.4% 19.26 42.635 4.40 90.39 0 4.9% 20.25 Capital structure Analysis Debt to Equity Ratio Times Interest Earned Debt Service Margin ANF Liquidity Analysis Current ratio Quick asset ratio Accounts recevable turnover Days supply of inventory Inventory turnover Days supply of receivables Working capital turnover 2001 1.8% 66.24% 43.465 1.57 82.57 1.505 1.22% 1.73 4.99% 28.77 17.36% 2.54 2.6% 12.38 188.3% 63.56 18.37 30.79 161.1 Profitability Analysis Gross profit margin Operating expense ratio Net profit margin Asset turnover Return on Assets Return on equity 66.42 1.34% 40.98 86.1 0.91 13.395 12.95% 41.3 4.84% 33.9 0 0.01 82.7 8.15 2005 43% 22% Profitability Analysis Gross profit margin Operating expense ratio 54 .74 0.475 2001 54% 22% 2002 2.885 74.275 27.38 17.04 1.28 58.64 2003 2.235 15.04 32.5 14.71% 1.29 50.7 54.36 2002 53% 22% 2003 2.745 56.4 28.6 9.24 52.35 55.6 42.2 6.13 2005 1.465 1.315 12.68 2004 44% 22% 2005 2.81 22.01% 1.40% 19.08% 28.96 1.Return on Assets Return on Equity 15% 21% 2001 0.4% 12.75 3.85 112.3 0 0.7 25.1% 19.61 67.59 78.4 82.655 16.50% 17.5% 12.8 22.9 1.9% 12.58 0.36 11% 16% 2002 0.93 2003 51% 22% 2004 2.7 16 29.70% 25.30% Capital Structure Analysis Debt to equity ratio Times interest earned Debt service margin 1.82 6% 9% 2003 0.915 7.01 24.14 2002 2.84 30.5 21.3 41.05 5.195 15.19 27.2% 10.73 17.87 66.4 2004 2.79 16% 22% 2004 0.

17 4.335 136.715 20% 28% 13% 1.63 15% 21% 8% 1.895 2004 0.675 16% 25% 9% 1.Net profit margin Asset turnover Return on Assets Return on equity 9% 1.625 68.38 2002 0.3 2.125 55 .905 24% 34% Capital Structure Analysis Debt to equity ratio Times interest earned Debt service margin 2001 0.45 59.1 7.375 72.67 0.96 2003 0.325 1.665 14% 19% 12% 1.575 2005 0.3925 27.

974.999 26.000 684.10% -25.689.538.899.000 1.629.522.223 10.848 5.552.048.57% 7.000 1.904.00% 100.488.90% 64.00% 100.363 47.606.000 49.07% N/A 3.960 2.000 ($3.000.83% 27.00% 100.371.218.455.000 4.000 8.000.000 461.000.00% 47.863.902.60% 41.000.478 16.843 9.519.451.10% -30.000.000 621.08% 100% 34.10% 40.239.000 8.000 5.09% -37.101 2.000 638.622 2.826 17.194.863.601.000 9.000.404.141.399 8.546.000 1.035.000.800.63% 0.150.000.10% 3.880 6.602.000) 2.898 7.250 11.978.000 159.10% 40.56% 2.000) (13.000.000 (8.000 15.25% 0.472.78% 64% 22.401.819.16% 40.00% 100.84% 42.20% ($0.00% 100.000.50% 34.000) (2.00% 19.00% 100% 33.471.696.383.000 357.675.408.000.411.000 8.10% 47.291.17% 69.669.173.073 6.16% 40.10% 14.000) (3.000 7.56% 10.30% 8.00% 47.800 1.80% ($0.733.000 4.60% 12.326.10% 14.00% 100% 11.76% 0.000 4.000 N/A 1.000 N/A N/A 1.480 5.738.000 4.000.000 7.000 9.000 1.360 2.033.044.000.245.212.000 49.000 ($3.934.777.79% 7.896.632.792.000 872.945.00% 47.525.000 12.17% -33.16% 40.811.00% 100% 33.000 2.000 3.00% 100.42% 0.00% 53.238.00% 100% 33.49% 64% 22.000.794.181.000 303.726.500 5.756.00% 47.00% 53.00% 100% 33.778.841.70% 21.162.413.000 1.884 3.00% 20.421 7.969.685.634.000 1.10% 4.000 2.000) 4.613.16% 40.93% 100.91% 11.193.174.874.633.000 2.00% 100.600.980.000 49.333 6.575.000) (7.000.00% 53.928 6.000 49.75% 100.924.000.000.000 N/A 499.783.10% 3.000 78.875.000) 4.461.000 294.744.061.904.000.2 Balance sheet Actual Balance Sheet 2001 Assets Current Assets Cash and Equivalents Merchandise Inventory Other Current Assets Total Current Assets Property and Equipment Leasehold Improvements Furniture and Equipment Land and Buildings Construction on Progress 1.000 11.000.468 7.081.233.580.16% 40.908.908.000 780.00% ($0.20% -0.10% 14.591.119.80% 12.91% 64% 22.25% 39.740 Accumulated Depreciation and Amortizatio ($1.820.42% 82.889.000 917.800.472.560.000.276.81% -0.000 513.000 1.040.644.21% 70.186.322 3.725.14% 9.709.182.936.896 3.000 6.00% 22.000 2.70% 10.73% 1.000 909.711.80% 27.090.009.00% 53.520 21.77% 27.00% 100.818.356.00% 47.563.308.36% N/A 5.36% 100.000 (16.981.611.000 3.239 41.289.000 16.496.400 12.000 4.966.000 1.84% 5.000 8.00% 8.89% 64% 22.041.451 18.486.10% 28.925.780.000) 3.890.000 7.00% 47.928.336.241.775 12.301.971.632.99% 17.404.832.000 779.67% 4.714.00% 0.10% 3.501.911.654 3.574.658.219 11.000 1.120.524.000.750 5.430.27) 57.55% N/A 14.000 N/A 10.207.000 6.00% 100% 33.000 4.86% 16.64% 22.905.750.127.10% 14.16% 40.00% 0.000.161.22% 20.000 6.240.209.103.145.000.000 385.979.00% 100.98% N/A 27.000.000 1.87% 13.00% 1.245.000.278.127.000.32) 54.000.073 4.000 4.739.35% -0.000.109 19.48% 46.799.000 4.35% 0.514.455.115 8.51% 0.766.397.236.000 942.725 6.480.000) 3.476 9.000.480.368.000.000 49.000 49.000 3.000 7.701.859 1.000.878 5.57% 39.000 300.000 2.90% 25.000 5.56% 11.431. at Cost Total Shareholder's Equity Total Liabilites and Shareholder's Forecasted Common Size Balance Sheet 5.000) (12.000 4.745.209.000 385.000 564.765.000.000 2.00% 47.34% 43.600 2.055.839.000 202.000.000 3.000.000 331.42% -0.012.933.000 2.000.000 408.000 250.000 (61.10% 58.156.000.715.000 10.648.327.826.24% 0.942.000.720.70% 3.242.00% 20.77% 100% 22.000 48.824.647.393.176.000 2002 2003 2004 2005 Forecasted Balance Sheet 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2.961.00% 53.854.633.000.000 2.000 2.711.515.10% 14.105.00% 100% 33.34% 64% 22.947.13% 7.166.15% 5.542.294.80% 12.825.056.00% 0.581.67% 64% 22.000) 4.000 286.94% -0.326 9.000.000 505.000 10.841 Figure 1.000.115.000) Propertry and Equipment Net Lease Rights and other Assets Total Assets Liabilities and Shareholder's Equity Current Liabilities Notes Payable Current Maturities of Long Term Debt Accounts Payable Accrued Expenses and other Current Liab Income Taxes Payable Total Current Liabilities Long-term Debt Deferred Lease Credits and other Liabilitie Total Liabilites Shareholder's Equity Common Stock Additional Paid-In-Capital Retained Earnings Accumulated Other Comprehensive Losse Deferred Compensation Treasury Stock.749.986 3.00% 53.22% 9.339.277.00% 22.22% 64% 33.445 3.153.000.78% 0.000 4.00% 0.012.967.32% 0.445.212.00% 53.067.057.000.000.379.00% 100% 33.000 984.614.307.22% 53.35) 32.456.577.814.49% 62.084.000 3.000) (2.425.000 49.000 ($2.223.191.410.486.426.000 615.000 N/A 2.10% 14.000 2.000 7.591.888.180.00% 100.773.000 6.64% N/A N/A 14.500 10.279.375.117.050.000 49.141.223.600 2.566.067.62% 6.00% 53.000 335.08% 64% 22.47% 0.845.29% 57.531.000 49.722.739.438.855.90% 100.64% 100.144.80% 37.000 3.674.158 1.685.831.635.656 3.550.396 22.574.000 581.927 10.89% 100% 21.000 4.000 N/A 283.159.368.33% 56.796 8.581.049.173.00% 56 .224.797.35% 6.000 7.004.00% 100% 33.000 5.344 14.00% 19.000.000) 3.097.505.376.000.973.685.616.000.00% 0.477.000.092.107.004.00% 53.00% 21.202.040 13.000 17.805.70% N/A N/A N/A N/A N/A 33.431.000 558.101.826.916.819.246.65% 0.00% 21.756.10% 14.704.959.692.000 1.721.000 2.052.047.901 4.012.000.424.60% 34.304.000 924.39% 0.10% 14.26% 0.961.022.486.261.16% 40.388.458.00% 100% 33.111 2.424.400 5.000 7.08% 64.304 4.10% 14.212.00% 22.623.500.000 4.595.332.353 13.074.963.Figure 1.10% 14.261.000 131.000) (2.658.739.996 20.000 31.290.50% 2.56% 15.14% 3.320.000 (20.843.12% 3.384.067.34% 18.000 1.29% -0.128.484.00% 53.272 23.43% 60.20% 58.000 1.000 2.605.493.500.158.255.274 2.000 246.16% 13.318.28% 64% 22.776.82% 5.047 16.00% 23.196.088.26% 31.227.84% 7.565.363 7.373.290.722.29% 10.087 7.000 732.09% 25.00% 21.000 9.250 8.000 49.000 6.000 (9.680 4.16% 40.000.91% 11.000 13.000.800 5.50% 2.731.000) 3.000.052.010.351.418.162.52% 2.000.675 8.70% 9.396.798.434.000.000 11.339.000.166.51% 64% 22.326.31) 38.007.16% 40.000.000 48.60% N/A 100% 22.203.634.253.677.55% 8.780 1.107.00% 0.824.492.691.083.942.000.07% -0.819 4.879.785 3.306.091 5.3 Proforma Balance sheet Actual Common Size Balance Sheet Assets Current Assets Cash and Equivalents Merchandise Inventory Other Current Assets Total Current Assets Property and Equipment Leasehold Improvements Furniture and Equipment Land and Buildings Construction on Progress Accumulated Depreciation and Am Propertry and Equipment Net Lease Rights and other Assets Total Assets Liabilities and Shareholder's Equity Current Liabilities Notes Payable Current Maturities of Long Term D Accounts Payable Accrued Expenses and other Curr Income Taxes Payable Total Current Liabilities Long-term Debt Deferred Lease Credits and other Total Liabilities Shareholder's Equity Common Stock Additional Paid-In-Capital Retained Earnings Accumulated Other Comprehensiv Deferred Compensation Treasury Stock.000 193.435 4.178.000 904. at Cost Total Shareholder's Equity Total Liabilites and Shareholder's Equity 46.000.588 15.116.000 49.000) (2.500 7.287.975.000 N/A N/A N/A N/A N/A 3.241.000 49.794.000 1.55% -0.066 5.406.000.092.00% 47.295.29% 0.23% 53.000.340.343.000 2.563.09% 100% 13.000.30% ($0.241.70% 62.16% -26.080.000 368.893.16% 40.591.00% 47.000.000 5.000 3.

00% 62.000) 3.50% -0.920.952.00% 100.500.255.00% 100.506.555 610.06% 3.64% 10.915.33% -0.918.36% 8.212.652 16.00% 35.188.385.600.04% 7.311.806 2.00% 100.01% 3.32% 3.886.40% 26.748.99% 4.000 2004 15.863.139.00% 37.288.04% -1.000 3.49% 112% 65.338 1.000 5.000) 1.940 4.500.920.000 504.00% 35.150.956 8.220 1.671.900.00% 26.030.10% 1.418 3.300 25.479 33.64% Figure 1.70% -1.920.38% 13% 9.34% 4.920.000.00% 100.933 944.68% 21.514.920.674.035.31% 4.17% 4.70% 5.567 (155.64% 8.040.21% 2013 2014 2015 100.110 29.552.029.258.652 2015 51.847.32% 36.04% -1.32% 7.128 6.920.842 7.000.000) 1.00% 65.15% 3.846.000 2.502.000.64% 26.834.835 18.50% 2.267.212.000 249.629.765.000 4.075.886.00% 35.60% 39.4 Income Statement The Gap Inc: Actual Income Statement 2001 Net Sales COGS Gross Profit Operating Expenses (Selling & Other) Operating Income Net Int Inc & Other EBT Income Taxes Net Income 13.381.000 5.50% -1.811.406 1.893 5.16% Average Growth Sales (Sustainable Growth Rate) COGS Growth Rate GP=Sales-COGS Selling Growth Rate 112.063.000.743.668 1.050.000 1.80% 38.863.461.007 3.412.400.018 (155.000.380.983.481.80% 38.000 (95.36% -1.00% 100.710.406 (155.16% 4.40% 7.674 12.622 Forecast Income Statement 2008 22.04% -1.61% 23.469 11.398.164.00% 65.852 1.162.00% 11.187 10.64% 26.372 7.465.64% 26.85% -1.000 1.00% 35.927 1.32% 3.158.000) 1.36% -0.000.32% 7.64% 26.680.000.224.00% 65.074.770 691.316.044 4.975.23% 2012 100.073.204 14.900.797.000 323.000 4.80% 65.400.70% 4.964 2013 40.531 2011 32.00% 65.706.257.90% 70.000 877.179.42% 0.279.872.279.371.561.000.817.000) 4.117.000 (213.597.000.661.000.40% 60.000.824 537.04% -1.870 2.82% -5.926.437.000 9.04% -1.846.000) 1.00% 100.00% 100.20% 35.00% 65.549.018 1.37% 4.007.623.00% 35.400.095 1.000 9.60% 2.138.04% -1.031.375.727 2.879.525.00% 65.442 1.179.00% 100.486.000.550.598.920.96% 26.716.178.800.868 13.568 21.299.40% 38.445.524 9.663.099 8.49% 104.000) 2.434.000 6.000 2006 18.247.45% -4.704.50% 7.000 9.179 (155.329.918 2009 25.000.032.728.50% 103.000 722.265 13.858.089.288 12.505.993 10.20% 40.6 Cash Flows 57 .56% 2.600.370.655.824 (155.000.243.764.715.45% 3.64% 26.915 2.00% 65.96% 1.401 783.30% 6.500.541.447.821 15.900.80% 8.000 8.000 1.673.256.000.000.36% 8.00% 37.200.080.61% -0.154 2014 45.30% -1.012.000 1.947.64% 8.031.147.000.973 885.32% 7.281.07% 3.000.00% 26.770 (155.57% 39.824.25% 4.927 (155.00% 26.855.681.10% 66.19% 4.498.920.32% 7.444.000.600.90% 34.000 4.924.04% 3.00% 25.000) 800.442 1.161.433.968.000) 3.00% 100.840 11.115.582.121 Sustainable Growth Rate = Sales Growth Rate COGS Percent of sales GP=Sales-COGS 2003-2005 Income Tax Provision of NI Average last 3y Shares Outstanding in 2005 29.900.721 3.36% 8.50% 65.460.885.913.000) 2.089 831.266.749.689.706.000 (7.96% 38.28% -26.25% Figure 1.000 9.706.486.102.381.900.762.000 2002 13.113.32% 7.973 (155.90% 12.250.500.000.00% 35.60% 2.00% 100.28% 4.806.20% -1.997.879.00% 35.04% 16.243.619.070.092 1.77% -5.44% -2.130.50% 27.80% 26.50% 27.555 (155.64% 26.450.995.36% 8.518.32% 7.60% 11.36% 8.923 2012 36.00% 65.36% -1.125.000 3.00% 35.700.296.000 1.599.11% 4.920.460.000 478.04% 7.694.000) 1.50% 10.000 2005 16.438 6.000.261.10% 29.109.09% 6.058.391 26.000) 2003 14.95% 2.702.13% 3.122.765.462.401 (155.143.824 9.920.000) 1.29% Skepticism Average Growth 4.98% 3.900.000 4.025 1.643.309 2010 28.982.639.25% 10.00% 62.000 (211.403.304.151.611 17.36% 8.381.00% 35.454.000) 1.5 Proforma Income Statement Revenue COGS Gross Margin Other Expenses (Selling & other) Operating Margin Net Int Inc & Other EBT Margin Tax Rate Net Margin The Gap Inc: Common-size Income Statement Forecast Financial Statements 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 100.Figure 1.497.000 653.554.175.760.854.218.860.796 6.00% 65.400.736 2007 20.000.04% 99.400.081 2.00% Plus Growth Average 39.567 1.000 (196.000 3.64% 26.394 14.04% -1.973.000 337.274.735.00% 11.085.179 1.418.000 (62.000) 2.318.00% 100.32% 7.36% 8.498 23.683.369.00% 100.000) 241.

628) ($995.000.072.627 $822.000 2004 $1.212.561.352.000 $408.000) ($42.794.478) $ 2.000.000 $706.431.000) $5.000) ($1.273 $213.000 $33.000.000 $675.000) $877.2001 Cash Flows from Operating Activities Net earnings (loss) : Depreciation and amortization Tax benefit from exercise of stock options and vesting o Deferred income taxes Loss on disposable and other Change in operating assets and liabilities: Merchandise inventory Prepaid expenses and other Accounts payable Accrued expenses Deferred lease credits and other long-term liabilities Net cash provided by operating activities Cash Flows from Investing Activities Net purchase of property and equipment Proceeds from sale of property and equipment Purcase of short term investments Maturaties and sale of short term investments Restricted cash Acquisition of lease rights and other assets Net cash used for investing activities Cash Flows from Financing Activities Net increase (decrease) in notes payable Proceeds from issuance of long-term debt Payments of long-term debt Issuance of common stock Reissuance of treasury stock Net purchase of treasury stock Cash dividends paid Net cash provided by (used for) financing activities Effect of exchange rate fluctuations on cash Net increase (decrease) in cash and equivalents Cash and equivalents at beginning of year Cash and equivalents at end of year $621.000.316.000.000 ($1.000) $3.252 $ 1.554) $163.194.000.160.000.000 ($629.872.000.035.479.261.568.916.000.000.105.000.942.000.896.749.121 $747.000.147.512.882.000.027.531 $ 1.972 ($747.000 $0 $152.000) $1.000 $58.255 $ (294.291.532 5.749.000 $1.379.839.000.000 $7.000.000) $42.000.389 $904.224.000 ($766.000.164.486.000 2002 ($7.000.674.261.420.832 ($464.593 $53.000) $0 $0 ($668.944 $ 2.000) $1.247 $ 2.060) ($10.000) ($734.000) $555.307.558.628 $995.000 ($13.032.000.000.000) $450.000.444 $57.000.035.431.000) $1.000) ($950.000 $44.140.602) $179.000.652 $ 2.000 $3.119.000) $626.444.142 $ (391.346.000) ($26.303.055.000.000.000) ($41.027.000 ($38.914.000 ($1.000 ($510.091) ($1.255 $ 3.000 $385.000.545.070.000.634 ($329.592.600) ($1.000.094.000.738.000) $42.000.218.000.000) $0 ($16.285.000 ($454.873 $679.739) $263.129 $ 3.955.628) ($995.371.560.000.756 $ 4.122 ($293.000 ($940.000) $54.389) ($904.407.000 $ $ $ (186.382) $239.205.000 $250.000.000 $ $ 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 831.000) $2.000) $28.648) $ 3.205.603.265.790 $53.154 $ 2.000.846) $148.703) ($617.226) $ 2.694.639 $561.390.000.000.000 ($261.291.641 $ ($510.270.000.887) $217.874.511 $ 1.639) ($561.000 $1.000) ($258.000 $2.873) ($679.389) ($904.000.060) $2.000 ($392.853) 4.000.000 $ 2.000.027.044.000 ($78.000.000.245.796) 902.824.000) $271.488.456.000 $1.000 $6.000.497.000 $101.843 $ 1.000) ($636.000 $408.000) ($75.627) ($822.000 $220.847 ($414.778 $ (267.869 $ 1.245.481 $ (323.620.000) ($38.434.058.236.615 ($521.000 ($976.000 2005 $1.279.964 $ 1.997 $53.616 $ (243.007) $135.333 $48.532 $ (473.000.000 ($785.560.794.000) $249.314 ($655.377 ($584.115.000.549.592.973.000.000) ($1.927.000 $337.020.000 $47.786.000.000) $1.000.609 $54.000 $27.616 $ 58 .385 2.000) $85.000.000) 2003 $478.000.516) $197.000.776) $ 4.506.778 $ 2.000.000 $1.000.000.000 $117.000) ($18.497 ($369.826.129 $ (356.060 $70.169.328.000.923 $ 1.000.444.614) $ 3.096.067.598.000.150.660 1.000) ($61.000 ($16.000 $5.000 ($80.000.000) ($79.000.365.804.600 $1.357 $54.916.318.813.000) $9.627.600) ($1.294 $ 999.007.000) $2.000.384 $2.000 ($20.000 $10.000 ($472.000) $33.627) ($822.204.534 $ 2.218 ($262.252.000 $5.549.000 $2.000) $130.000.000) $21.000.000.595.000.703) ($617.000 $55.091 $1.094.236.736 $ 944.000.000.000 $0 $120.204.000.796.000.616) $ 2.000 ($3.000) $159.000 $22.000) $810.000) $0 ($1.000 $408.000 ($11.000 ($56.660) 1.873) ($679.000 $54.000 $1.145.000 $590.000 ($13.142 $ 4.000 $1.000.000.031.309 $ $510.737.279.000) $2.204.162) $ 2.091) ($1.000 ($42.000 $26.000 ($250.794.242.000 $62.000 ($342.000.749.212.000 ($90.000) ($112.660) ($747.942.000.303.000 $2.541.000) $139.000) $442.162.000 $620.245.000) ($76.000 $72.418.000) $3.622 $ 1.000 ($442.081) $111.000.738.000 $31.078.000 ($79.373.000) $59.000 $130.639) ($561.000.202.558.000.703 $617.000 ($2.105.333.000.000 ($308.542.020.094.307.431.000.398.756 $ (430.243.000.000 $0 $0 ($871.918 $ 1.000 $108.000 $2.481 $ 3.000.317.000 ($28.000.000.000.616 $ 2.000) $1.000 $1.000 $160.764.205.425.013) $ 3.465 $53.000.674.

711780248 797347895.00 (1.00) $ 0.18 8 2013 $2.16 $ $ $ 902.271.628.00 $ (617.565.18 4 2009 $1.4039 819312683.52 -4.37 19.601.169.145.769 4 7.252.00 $ 1.944.660.873.3220 825015860.18 6 2011 $1.843.04 21.162.18 9 2014 $2.339.060.035.301.511.48 12.87 17.00) $ (617.17 12.01 0.204.6 0.935.00) $ 1.00) $ 2.89 17.Figure 1.14 12 -36 -12 15.060.030.00) 2.63 0.511.39 19.889.120.18 $ 0.703.00 $ 1.18 3 2008 $1.035.598.000 0.094.917.5714 6 18 -18 -6 -3.562.18 7 2012 $2.39 G 5.00) $ 2.434.97 $0.39 860559000 11.00 $ (679.628.31 12.287.627.559.165532463 6.561.204.145.07 13.095 1.894 3.247.639.13 9.85 17.41 $0.404 0.425.920.094.875.25 $0.00 $ (510.470.00 $ 999. 0 0.601.33 0.25 $0.00 17.601.169.64 Assume Dividend Perpetuity Grows at 2% per year for initial perpetuity Vf Market Value Market Value Weights WACC Solve for Ke given previous information 12 14.627.5 4.407.055.00 9.1 15.389.4523 816643753.00) $ (995.08 1.641.12 11.2 0.48 Overvalued (<90% Undervalued (>110%) 0.843.2 36 -12 -7.41 19.11 13.603.166 0.125 10.3846 1.34 96% Ke Figure 1.407.700.270.00 $ 2.105 1.572.00) $ 1.04 $0.2 0.79 10.565 2.5 -9 -4.561.724.527.00) $ 1.39 0.18 1.148.527.55 0.6355 807798959 0.1655 2 2007 $1.162.94 17.641.49 5112000000 13.3 0.00) $ 7 2012 $2.138.02 0.67 15.933.279.18 5 2010 $1.425.07 2.48 0.00) $ 1.00) $ (747.819.00 $ (904.10 $0.919624793 0.81 $0.7 Discounted Dividends 0 2005 EPS (Earnings Per Share) DPS (Dividends Per Share) BPS (Book Value Equity per Share) Cash From Operations Cash Investments PV Factor PV of Dividends Total PV of Annual Dividends Continuing (Terminal) Value Perpetuity PV of Terminal Value Perpetuity Estimated share value at the end of 2005 0 0.389.534.714 2.18 10 2015 PV Factor PV of Free Cash Flows Total PV of Annual Free Cash Flows Continuing (Terminal) Value Perpetuity PV of Terminal Value Perpetuity Value of Firm Book Value of Liabilities Estimated Market Value of Equity Number of Shares Estimated Price per Share (end of 2005) Observed Share Price $ $ $ $ $ $ 7.41 $0.18 $ 902.425.00) $ 1.00 $ 1.2 14.00 $ 2.6 21.434.00) $ 2.032.981.804.8 27.869.600.569 24.055.039.641.59 11.64 $ 7.81 $0.34 100% Vd 512000000 4% Kd 6 Ve 13.027.18 3 2008 $1.216.247.10 $0.04 $0.00 $ 1.60 $0.38 24.60 $0.27 5.73581 17.252.00) $ (679.49 15.8 Free Cash Flows 0 2005 EPS (Earnings Per Share) DPS (Dividends Per Share) BPS (Book Value Equity per Share) Cash From Operations Cash Investments Cash Flow to Firms Assets (Free Cash Flow) 6.080 0.091.18 5 2010 $1.29 13.00 $ (561.42 11.17 13.00 $ 1.374.119.833.027.63 0.000.116.00 $ (904.095 0 0.588.50663 812562675 0.032.76 14.603.892857143 805862440.4 0.972.5 14.032.05 4 6.854.105 14.294.18 4 2009 $1.100 0.00 $ 2.920.18 $ 10 2015 0.893.78 15.4 13.00 $ 1.00) $ 999.60 $0.00 $ (561.00 $ 1.00 1 2006 $0.797193878 796974308 WACC 0.00 $ (995.00 $ (822.2 -5.0874 2.00 $ 1.64 g 17.869.847.000.592.00) $ (1.805.162.703.944.3606 822240926.14 12 -36 -7.04 5.935.270.130 0.987.29 21.56743 809090248.040 0.32 -14.119.804.34 860.37 14.660.27 5.00 $ 2.60 $0.00 $ (822.279.27 14.1 23.280.225 0.18 999.18 6 2011 $1.933.592.16 1 2006 $0.060 0.56 15.598.46 15.404 Value of Firm Book Value of Liabilities Estimated Market Value of Equity Number of Shares Observed Price per Share (end of 2005) 12.534.17 0 59 .091.981.639.876 19.028.97 $0.935.13 21.03 0.059496568 Ke g 0.294.30 $0.384.972.603.6 -3 0.00 (1.600.876 19.00) 2.4 3.18 9 2014 $2.00 $ 2.14 Overvalued (< 90%) Undervalued (> 110%) 0.47 19.044.00 $ (747.3 0.353.00 $ (1.3 -5.8 $ 0.00 $ $ (510.112.30 $0.115 12.00) $ 902.873.4 0.48 17.00) $ 1.5 -3.18 2 2007 $1.120 20.05 g .000.087.2857 1.044.18 8 2013 $2.95 0.115 1.

0874 15.577 30.9932 11.11 $2.06) 6 (0.01) (0.97 $0.75 0.06) 7 (0.83% 15.0719 17.4548 21.74% -2.24% 13.5% 0.926 0.74 (0.94 0.10 $0.32 $0.18 7.12% Sensitivity Analysis g 0.06) 5 (0.97 $0.1 $7.06% 15.03) 0.81 $0.35 0.06) 8 (0.60 $0.43% 14.681 0.48 0.48 $0.18 15.97 $0.22 7 2012 13.96 $2.22 0.20 9 perp 2014 17.12 Actual Price per share Growth $22.97 $0.44 $4.75% 12.05 0.17 11.630 0.08 0.60 $0.94 4 5 Forecast Years 2009 2010 8.33 0.88% 13.60% 13.35 0.32 2010 9.583 0.794 0.15 0.54 $5.18 13.53 $0.04 0.62 2015 6.82% 15.21 0.15 0.18 $0.01 $3.69 2013 11.33% 20.2921367 2006 6.16 1.95 $0.18 19.18 7.03 0.08 $2.95 2 2007 6.4274 13.87 0.18 6.15 $7.94 10.16 0.90 2012 10.06 0.19 $3.97 $0.97 $0.01 0.53 (0.16 0.20 $7.41 0.00 (0.56 0.2444 60 .41 $1.08 0.48 2014 12.29 0.08 10.17 $1.11 $3.0 LR ROI Perp 1 2005 Beginning BE (per share) Earnings Per Share Dividends per share Ending BE (per share) Ke ROE Growth inBVE Actual Price per share Average ROE Average Growth in BVE LRResInc Perp Value Estimated Value $17.07% 15.01 0.77% 13.08 8 2013 15.11 $0.18 12.62 0.22 $2.97 $0.18 10.28 0.18 8.74 $0.25 $0.29 $5.58 0.21 $2.97 $0.27 2015 (0.16 0.86 $2.49 $4.76% 15.18 10.34 $4.49 0.20 $2.03) 1 2006 6.73% 13.11 2011 10.30 $0.07% 0 0.06 0.12% 14.735 0.02 0.10 0.60% g 15.10 0.95 $1.07 0.16 $0.18 17.03 0.06) 4 Forecast Years 2009 8.97 $0.96% 15.69 $0.41 avg gr 14.4373 63.68 0.6177 12.25% 14.18 8.857 0.540 0.97 2.06) 3 2008 7.63 6.9 Residual Income (0.16 $0.14 0.06% 15.55% 100.05 $7.95 2 2007 6.18 11.Figure 1.81 0.18 6.87 3 2008 7.04 $0.44 $5.16 $3.59 $1.26 $2.97 $0.60 6.64 15.44 ValuePercent 77.500 (0.59 6 2011 11.06) 0 2005 Beginning BE (per share) Earnings Per Share Dividends per share Ending BE (per share) Ke "Normal" Income Residual Income (RI) Discount Factor Present Value of RI BV Equity (per share) 2005 Total PV of RI (end 2005) Continuation (Terminal) Value PV of Terminal Value (end 2005) Estimated Value (2005) 0.5193 15.06) 9 perp Figure 2.87 $1.18 9.16 0 $7.90 $0.02 1.48 0.00% Ke 0.1 0.62% 14.18 10.18 13.59 $5.

98 $1.98 $1.99 $3.01 $0.97 $0.71 $2.97 $0.1 Abnormal Earnings Growing 1 2005 EPS DPS DPS invested at 17% (Drip) Cum-Dividend Earnings Normal Earnings Abnormal Earning Growth (AEG) $1.72) 0.0874 0.17 0.05) 0.12 0.72) $0.2 Weighted Avg.98 $1.01 $0.22 0.624 ($0.98 1.00 $0.01 $0.855 ($0.27 0.16 $7.89 $3.01 $0.57 0.86 $2.97 $0.97 $0.18 $0.98 $1.577 0.04) ##### 0.00 $0.97 $0.107 61 .1 $6.0248 -0.92 $4.01 $0.01 $0.97 $4.31 -0.493 ($0.06) 3 Forecast Years 2008 $0.18 $0.05 ($0.03) 0.15 $6.05 ($0.05 ($0.0817 $6.12 Actual Price per share$17.05 ($0.63 0.18 $0.41) 2 2007 $0.04) 0.97 $1.14 0.534 ($0.0188 Ke 0.64 Figure 2.0265 0. Cost of Equity 5-Year Constant Maturity Risk Free Rate Months Beta -0.97 $0.38) 0.04) 0.81 $2.29 ($0.18 $0.97 $0.05 ($0.05 $6.675 ($0.97 $0.40 ($0.87 $4.18 $0.18 $0.02 $4.94 $3.56 $2.06) 0.01 $0.0216 0.61 $2.76 $2.456 $0.06) ##### 4 5 6 7 8 9 10 Perp PV Factor PV of AEG Core EPS Total PV of AEG Continuing (Terminal) Value PV of Terminal Value Total PV of AEG Total Average EPS Perp (t+1) Capitalization Rate (perpetuity) Value Per Share Ke g 0.01 $0.06) 2009 $0.00876 -0.0817 0 $0.91 R^2 -0.06) 2010 $0.924 ($0.1 0.84 $3.24 0.06) 2011 $0.18 $0.98 $1.Figure 2.0108 0.18 2006 $0.730 ($0.97 $0.00 ($0.05) 0.05 ($0.18 $0.06) 2012 2013 2014 $0.66 $2.98 $0.18 $0.98 $1.98 $1.0265 0.29 $0.08 0.06) $0.71 $2.05 ($0.00 Sensitivity Analysis g 0 Ke 0.01 $0.24 60 48 36 24 Yahoo Finance -0.790 ($0.05 $1.

268583725 0.015258216 0 0.112.054 weight 2005 0 0.180751174 0.000 Long-term debt Senior convertible notes Lease incentives and other liabilities Total Non-Current Liabilities 0.000 $ 2.000 $1.000 $924.000.000 $984.012710485 0.000.000.012883881 $513.Figure 2.000 $78.067 0.000823944 0 $1.242.000.000.24256651 0.002569014 0.100352113 0.000 $ 5.0456 0.07 0.000.012652582 0.3 Weighted Avg.0524 0.0256 0.000.373.000 $2.054988517 62 .) TOTAL CURRENT LIABILITIES 0. Cost of Debt Interest Rate LIABILITIES AND STOCKHOLDERS' EQUITY Short-term borrowings ** Current maturities of long-term debt Accounts payable Accrued expenses and other current liabilites Other current liabilities (income taxes pay.240.000 Total Liabilities WACD 0.000.870.013348611 0.0497 0.192488263 0.000.

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