Gap Inc. (GPS) may intrigue many investors simply because it has dropped in price relative to the market over the last several months, making it somewhat attractive based on its price alone. In addition, some analysts such as Josh Arnold believe the market may be over reacting to the latest earnings results.
That said, Benjamin Graham, the father of value investing, taught that the most important aspect to consider is whether the company is trading at a discount relative to its intrinsic value. It is through a thorough fundamental analysis that the investor is able to determine a potential investment’s merits. Here’s an updated look at how Gap Inc. fares in the ModernGraham valuation model.
This model is inspired by the teachings of Benjamin Graham and considers numerous metrics intended to help the investor reduce risk levels. The first part of the analysis is to determine whether the company is suitable for the very conservative Defensive Investor or the less conservative Enterprising Investor, who is willing to spend a greater amount of time conducting further research.
In addition, Graham strongly suggested that investors avoid speculation in order to remove the subjective elements of emotion. This is best achieved by utilizing a systematic approach to analysis that will provide investors with a sense of how a specific company compares to another. By using the ModernGraham method, one can review a company’s historical accomplishments and determine an intrinsic value that can be compared across industries.
GPS data by YCharts
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Defensive Investor – Must pass at least 6 of the following 7 tests: Score = 5/7
- Adequate Size of Enterprise – Market capitalization of at least $2 billion – PASS
- Sufficiently Strong Financial Condition – Current ratio greater than 2 – FAIL
- Earnings Stability – Positive earnings per share for at least 10 straight years – PASS
- Dividend Record – Has paid a dividend for at least 10 straight years – PASS
- Earnings Growth – Earnings per share has increased by at least one-third over the last 10 years, using three-year averages at the beginning and end of the period – PASS
- Moderate PEmg (price over normalized earnings) ratio – PEmg is less than 20 – PASS
- Moderate Price to Assets – PB ratio is less than 2.5 or PB x PEmg is less than 50 – FAIL
Enterprising Investor – Must pass at least 4 of the following 5 tests, or be suitable for a Defensive Investor: Score = 5/5
- Sufficiently Strong Financial Condition, Part 1 – Current ratio greater than 1.5 – PASS
- Sufficiently Strong Financial Condition, Part 2 – Debt-to-Net Current Assets ratio less than 1.1 – PASS
- Earnings Stability – Positive earnings per share for at least 5 years – PASS
- Dividend Record – Currently pays a dividend – PASS
- Earnings Growth – EPSmg greater than that 5 years ago – PASS
|Value Based on 3% Growth||$38.11|
|Value Based on 0% Growth||$22.34|
|Market Implied Growth Rate||2.94%|
Balance Sheet – March 2015
Earnings Per Share
Earnings Per Share – ModernGraham
GPS Dividend data by YCharts
Gap Inc. is much more attractive as an investment than some of its competitors. For example, a ModernGraham valuation of Nike Inc. (NYSE:NKE) indicates the company is suitable for the Enterprising Investor but is currently overvalued. Ralph Lauren Corporation (NYSE:RL) is found as suitable for Enterprising Investors and is undervalued, but not as significantly as Gap Inc.
Gap Inc. is suitable for the Enterprising Investor but not the more conservative Defensive Investor. The Defensive Investor is concerned by the low current ratio and the high PB ratio, while the Enterprising Investor has no initial concerns. Therefore, all Enterprising Investors should feel very comfortable proceeding with the next stage of the analysis, which is a determination of an estimate of intrinsic value.
From a valuation side of things, the company has grown its EPSmg (normalized earnings) from $1.59 in 2012 to an estimated $2.63 for 2016. This level of demonstrated growth outpaces the market’s implied estimate for earnings growth of 2.94% over the next 7-10 years.
The company’s recent earnings history shows an average annual growth in EPSmg of around 13%. The ModernGraham valuation model reduces such a rate to a more conservative figure, assuming some slowdown will occur, but still returns an estimate of intrinsic value well above the current price, indicating Gap Inc. is significantly undervalued at the present time.
Disclaimer: The author did not hold a position in any company mentioned in this article at the time of publication and had no intention of changing that position within the next 72 hours. Logo taken from Wikipedia for the sole purpose of identifying the company; this article is not affiliated with the company in any manner.