Regression Analysis
Using the regression analysis, we are willing to reveal the real trend behind the growth multiples of the company, i.e. whether the trend in the financial multiples posted by the company is real or just inflated numbers. Stated otherwise, regression analysis is performed to understand how sustainable are the financial numbers and how can these historical trends help us in forecasting the future performance of the company.
The first two multiple analyzed were sales per share and EPS as these multiples reveals the amount of money the entity is making. Analyzing the trend, we witnessed that while the sales per share is increasing linearly, the EPS has more tidal and exponential growth rate. Another notable trend here was that EPS was growing at an increased rate compared to sales per share growth. While this situation is possible at times of buyback transactions, the same was also confirmed through the financial data for 2007-2014 that indicated that the number of outstanding shares of the company are decreasing and this may be the possible of exponential growth in the EPS multiple. The second possible reason for the exponential growth rate in EPS can be the increasing operating margin. However, our analysis revealed that over the period of seven years, the operating margin of the company has been fairly constant in the range of 41%-43%.
Henceforth, it was validated that higher rate of increase in EPS is because of the decreasing number of common shares of the company and not because of the increasing profits.
The next statistic we analyzed was the Cash Flow per Share, which in alignment with increasing earnings of the company has also witnessed an increasing trend. Most importantly, the increase in cash flow per share amount has also consequently resulted in an increase in free cash flow per share amount from 2011-2015, the period during which the company witnessed consistently high EPS. Important to note, the company has been efficiently utilizing its increasing amount of free cash flow for buy back shares and making dividend payments while keeping the leverage position constant. This trend confirms that while the management is optimistic of the future growth of the company, they wanted to do operate with minimum leverage and risk structure. It is because of this reason the R-square of long-term debt is merely 36.70%.The high stock price stability score of 55 assigned by Valueline also confirms optimistic future potential of the company.
Next, we compared the trend in net profit margin and operating margin and here also we found a sustainable trend with net margin sharing similar trend with the operating margin. Similarly, the trend in the net profit margins was also compared with the return on total capital and return on equity and here also we found that these three multiples shares high correlation and with the company operating with constant debt position, therefore, whatever increase in return the company is generating, is attributed to equity investors. Having a constant debt position signals two aspects: First, the leverage risk is constant over the years, and secondly, while the amount of buyback is increasing every year, the company will possibly be able to reduce the cost of equity as future investors will be ready to offer the capital at a lower rate on account of constant leverage risk and also because of managerial actions such as higher dividend payments and increasing buyback position, which signals confidence of the company’s management in the future potential. Additionally, the fact that dividend yield of the company, which was recorded at 4.2%, is significantly higher than the industry average of 1.7%, will also entice the equity investors of the company.
DuPont Analytics-GAP Inc.
While investors give due consideration to the ROE multiple of the company as the same reveals the margin being earned by the company on equity capital, however, the investors can be easily duped following possible manipulation of the inputs in the ROE multiple. Below we have decoded the ROE multiple of the company using DuPont Identity:
ROE: (Net Income/ Revenue)* (Revenue/ Total Assets)*(Total Assets/ Total Equity)
2013: (1280/16148)* (16148/7849)* (7849/3062)
= 7.92* 2.05* 2.58
= 41.88%
2014: (1262/16435)*(16435/7690)*(7690/2983)
= 7.67* 2.13* 2.58
= 42.14%
The above calculations reveal that the ROE multiple of the company has been majorly driven by the profit margins. However, during 2014, the profit margin of the company declined to 7.67% owing to higher proportional operating costs relative to the revenue figures. However, the downside of the net profit margin was limited by improvement in the asset turnover, which fueled the ROE from 41.88% to 42.14% in 2014 while the financial leverage multiple remained constant. Overall, an optimistic trend.
Growth Rate
Internal Growth Rate: ROA(1-Dividend)/(1- ROA(1-Dividend))
= (1262/7690)*(1-0.86)/(1-(1262/7690)*(1-0.86))
= 0.0228/0.977
= 2.33%
The above metric reveals that GAP Inc. can attain a growth of 2.33% without resorting to external financing resources.
Maximum Sustainable Growth Rate: ROE(1-Dividend)/(1- ROE(1-Dividend))
= ((1262/2983)*(1-0.86))/(1-(1262/2983)*(1-0.86))
= 0.0592/0.9407
= 6.29%
The above metric reveals that the company can attain a growth rate of 6.29% without any change in the leveraged position. Important to note, compared to Internal Rrowth Rate, Sustainable Growth Rate gives a better idea of the growth rate while keeping in line with the financial policy of the company. Anyhow, considering the compounded annual growth rate of 8.79% over the period of seven years(2007-2014), we believe that the company might need additional funding to maintain the growth rate in the revenue figures as its sustainable growth rate falls short of the existing growth rate in revenue figures.
Earnings per share
Referring to the past years financial statement of the company, we witness that even though the EPS of the company has increased by 36.89% on an annually compounded basis, however, the increase here cannot be rated as sustainable because of non-alignment of EPS trend with Sales per share growth. Stated otherwise, the EPS figures show great fluctuation every year with no fixed trend. For instance, during 2011, while the sales per share increased by 20.28%, EPS was down by -17.02%. However, in the very next year, while sales per share increased by 12.66%, EPS increased by 49.35%. Therefore, we will cut down the EPS growth forecast by one-third to 12.29%.
Dividend Forecasts
Over the past seven years, the growth rate in dividends declared has been linear and with Valueline forecasting the dividend growth rate at 9% for 2020, we believe that the growth rate is reasonable both fom the point of view past year dividend history and current dividend payment of $0.86/share. Therefore, taking the growth rate of EPS and dividend payment, we can estimate a forecast of returns over the next five years:
Calculating Discount Rates
Old Cost of Equity(Ke) Calculation= AAA Corporate Bond Rate+ Financial Risk+ Business Risk
= 4+ 2.50+ 2.19
= 8.69%
Here:
Financial Risk: Warren Buffet Factor recored at 2.5%
Business Risk: Risk Premium of 2.19% for a company with Baa2 rating issued by Moody’s
New Cost of Equity(Ke) Calculation= Risk free rate+ Beta(Return on S&P 500 Index- Risk free rate
= 1.88+ 0.95(6)
= 7.58%
Here:
Risk Free Rate: 10 year US treasury yield rate
Beta: Volatility of stock returns to the market index
Excess returns of the stock over the market index
As we may note, the discount rate calculated using the inputs of old Ke is higher than the one used for new Ke. The difference in discount rates calculated under both the methods is attributed to the method of evaluation of risk along with the risk-free rate. For instance, while for old Ke, the risk premium is a function of their financial strength and AAA-rated corporate bonds, for new Ke, the risk premium is accessed through beta and 10-year treasury bill rate. Although these factors often have a positive correlation, there will almost always be a difference in the two premiums. Therefore, considering the possible difference in discount rate under both the methods, the differential here of 1.35% is acceptable and subjective.
Value Line Legend Valuation
Value line has predicted the stock price at 9.5 times the cash flow per share. Therefore, considering the cash flow per share of 4.29/share, the intrinsic value is calculated to be $40.75/share. Compared to the current market price of $23.84/ share, the stock seems relatively undervalued signaling towards a long position in the stock.
Old Ke Valuation
New Ke Valuation
As we noticed, the outcome of discount models using both the discount rates reveals that the stock is currently undervalued and even when we restricted the EPS growth rate to one third of the present level, the stock is still having the potential to surge by more than 200% from the current price levels.
Conclusion
It is considerable that the stock price of the company has decreased by 40% over the past six months ending January, 2016. However, following our comprehensive analysis relating to the stock and financial numbers reported over the past seven years, we believe that the stock has a great upside potential from the current price level. While the three stock valuation methods also confirm undervaluation of the stock, the fundamental analysis also reassures the optimistic trend. Most importantly, even though the sales figures of the company has been increasing at a sustainable trend, however, increasing buyback transactions and dividend payments while keeping the leverage position constant signals that the management is confident of the future recovery of the company and since it is not taking any additional debt, the equity investors will probably offer additional funding at lower costs once the stock rebounds with the bullish run. Even the Valueline analysis report asserts that at the recent stock quotation, the equity has good 3-to-5-year recovery potential and a strong dividend yield of 4.2%, makes the stock a strong buy. Our analysis is also validated by other market analysts, where majority of them have given a buy and hold recommendation for the stock:
As a final recommendation, Gap Inc. is a solid investment opportunity where the management actions of buyback and increasing dividend payments reassures that stock has a great recovery potential and a timely entry into the stock will yield high capital gains and also dividend income for the investors.
References
Analyst Opinion: GAP Inc. (n.d.). Retrieved April 9, 2016, from Yahoo Finance: https://in.finance.yahoo.com/q/ao?s=GPS
Damodaram, A. (2016, January). Country Default Spreads and Risk Premiums. Retrieved April 9, 2016, from http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html
GAP Inc. (2014). Annual Report 2014. GAP Inc.
Industry Peers- GAP Inc. (n.d.). Retrieved April 9, 2016, from Morningstar: http://financials.morningstar.com/competitors/industry-peer.action?t=GPS®ion=USA&culture=en_US
Key Statistics: GAP Inc. (n.d.). Retrieved April 9, 2016, from Yahoo Finance: https://in.finance.yahoo.com/q/ks?s=GPS
Moody's Credit Research. (n.d.). Moody's upgrades Gap's senior unsecured rating to Baa2. Retrieved April 9, 2016, from Moodys: https://www.moodys.com/research/Moodys-upgrades-Gaps-senior-unsecured-rating-to-Baa2--PR_329902
Valueline. (2016). Analyst Report-GAP Inc. Valueline.
