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Summary

  • GPS shares have tripled in the past three years on strong operating results and a favorable retail environment.
  • Gap continues to increase guidance, providing upside catalysts for the stock.
  • Share repurchases and EPS growth will continue to boost shareholder returns going forward and GPS looks cheap at less than 14 times forward earnings.

Shares of Gap (NYSE:GPS) have soared in the past three years, tripling from $15 to the current $46+ shares trade for today. The company has been a poster child for success in the retail space with its distinct brands and wide reach with its footprint. Strong EBIT margins have boosted net income and driven the stock price ever higher and the company continues to impress with its operating results. The question for investors is whether or not this move can continue. In this article, we'll take a look at GPS' valuation in order to determine if it has a place in your portfolio.

(click to enlarge)

To do this I'll use a DCF-type model that you can read more about here. The model uses inputs such as earnings estimates, which I've borrowed from Yahoo!, dividends, which I've set at 10% growth annually, and a discount rate, which I've set at the 10 Year Treasury plus a 6.5% risk premium.

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

Prior Year earnings per share

$2.74

$2.96

$3.36

$3.81

$4.31

$4.88

x(1+Forecasted earnings growth)

8.00%

13.50%

13.30%

13.30%

13.30%

13.30%

=Forecasted earnings per share

$2.96

$3.36

$3.81

$4.31

$4.88

$5.53

Equity Book Value Forecasts

Equity book value at beginning of year

$6.79

$9.53

$12.65

$16.19

$20.20

$24.77

Earnings per share

$2.96

$3.36

$3.81

$4.31

$4.88

$5.53

-Dividends per share

$0.22

$0.24

$0.27

$0.29

$0.32

$0.35

=Equity book value at EOY

$6.79

$9.53

$12.65

$16.19

$20.20

$24.77

$29.95

Abnormal earnings

Equity book value at begin of year

$6.79

$9.53

$12.65

$16.19

$20.20

$24.77

x Equity cost of capital

8.90%

8.90%

8.90%

8.90%

8.90%

8.90%

8.90%

=Normal earnings

$0.60

$0.85

$1.13

$1.44

$1.80

$2.20

Forecasted EPS

$2.96

$3.36

$3.81

$4.31

$4.88

$5.53

-Normal earnings

$0.60

$0.85

$1.13

$1.44

$1.80

$2.20

=Abnormal earnings

$2.35

$2.51

$2.68

$2.87

$3.09

$3.33

Valuation

Future abnormal earnings

$2.35

$2.51

$2.68

$2.87

$3.09

$3.33

x discount factor(0.089)

0.918

0.843

0.774

0.711

0.653

0.600

=Abnormal earnings disc to present

$2.16

$2.12

$2.08

$2.04

$2.02

$2.00

Abnormal earnings in year +6

$3.33

Assumed long-term growth rate

3.00%

Value of terminal year

$56.45

Estimated share price

Sum of discounted AE over horizon

$10.41

+PV of terminal year AE

$33.84

=PV of all AE

$44.26

+Current equity book value

$6.79

=Estimated current share price

$51.05

As we can see the model produces a fair value of about $51, or around $5 higher than shares trade for today. That's a pretty decent margin of safety that is built into GPS right now so let's go ahead and understand exactly what we're looking at in order to evaluate the validity of it.

The model produces a fair value and not a price target. A price target involves taking some EPS estimate out in the future and projecting an earnings multiple onto it and producing a future value for the stock. The model, by contrast, produces a price at which GPS is a good buy today. In other words, the present value of the GPS' discounted future earnings stream including dividends is around $51, given the inputs I described above. That would imply that GPS shares are moderately undervalued at present and represent a buying opportunity.

If we take a look at the earnings estimate line in the model we can see that analysts are expecting roughly 13% annual growth in EPS for the foreseeable future. This seems very reasonable to me considering the terrific execution GPS is known for. In fact, that growth rate is nearly identical to GPS' recent years' earnings growth so the company has shown a propensity to grow earnings that quickly before.

But why has the stock tripled in the past three years? For one thing, retail sales continue to be strong, aiding GPS in getting people in the door and converting them to sales. GPS has certainly benefited from the more favorable environment for retail sales in recent years and it appears as though that environment isn't missing a beat.

The company is also executing on all fronts and planning aggressive expansion efforts to continue to grow its brands. The company owns some very high profile brands including Banana Republic, its signature Gap stores, Athleta and Old Navy. These brands all resonate with consumers at different spots in the income and discretionary spending spectrum, offering consumers of nearly every status a way to touch GPS. Gap's well diversified portfolio of apparel brands is one of its key strengths in my view and it is continuing to reinforce that as being the correct strategy.

In addition, margins have been on the rise at GPS, boosting EPS. Operating margin in the second quarter, for instance, was 70 basis points higher than it was in the comparable quarter last year, replaying a scenario we've seen many times from GPS. This company is growing top line sales, albeit at a moderate pace, but it is also showing some operating leverage as well, increasing the amount of each dollar in revenue it gets to keep as profit.

The company is also boosting EPS with its share repurchase program, retiring 9 million shares in the second quarter alone. I love share repurchases as they boost EPS every year after they are made and the cumulative effects continuously boost the company's share price. GPS is doing this and doing it well and it has served to increase the company's share price in recent years. I hope GPS continues to use excess cash to retire shares in the years ahead.

GPS has everything going for it right now; a favorable retail environment, a diversified portfolio of brands, growing revenue and expanding margins, and a buyback program that is boosting returns for shareholders. There isn't much not to like here and GPS shares have had good reason to triple in the past three years. Of course, the easy money has been made but that doesn't mean that you should avoid GPS. At less than 14 times next year's earnings GPS is hard to pass up here. The company's multiple is too low for a company with the history of growing EPS and the bright future that it has. I like GPS here for a long term buy.

Source: Gap Stores Looking Pretty Cheap Here