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Understanding the Interesting Dynamics of Gap's Business Performance and Valuation

The Gap's financial performance presents a compelling case study in specialty retail. Despite its steady earnings growth and high stock price at $55 per share, questions arise regarding the high P/E ratio of 35. While the retail industry's growth is limited by intense competition and low customer switching costs, Gap has successfully implemented a differentiation strategy aimed at moderate-priced brand development. Its consistently high ROE and profit margins reflect effective business operations. An analysis of the potential accounting practices and determinants of profitability offers insights into Gap's financial health.

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Understanding the Interesting Dynamics of Gap's Business Performance and Valuation

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  1. Why is the Gap Case Interesting? • Gap’s earnings had been increasing steadily through the date of the case • Gap’s stock price was $55/share, or 35 times of earnings • Why is The Gap’s P/E so high? • Good earnings expectation? • Too optimistic?

  2. The Specialty Retailing Industry • Growth is not expected to exceed overall economy-wide expansion • High level of competition • Many competitors • Low customers’ switching costs • Few barriers to entry • “Brand name” is not a crucial factor to scare new entrants

  3. Determinants of Profitability • Profit margin • High sales • High gross margin • Low operating expense

  4. Gap’s Business Strategy • Product differentiation strategy • Niche market: brand name at a moderate price • Brand development • Unique advertising • High sales; low operating expense; high inventory turnover

  5. High ROE and Why? Gap Limited Industry 1989 31.8% 31.7% 22.6% 1990 36.0% 28.5% 21.1% 1991 40.2% 23.5% 19.6% Observation: Gap’s ROE has been increasing and is much higher than The Limited and its industry average

  6. Accounting “Tricks”? • Probably not… • Unusual large amount of earnings? • Earnings too much higher than OCF? • Abnormal changes in inventory? • Receivables too high? • And, leases?

  7. Decomposition of ROE-1991 PM Turnover Leverage Gap 9.2% 2.618 1.683 Limited 7.0% 1.997 1.830 Industry 5.3% 2.141 1.874 Observation: Gap had high profit margin and assets turnover High gross margin High fixed assets turnover; investment in receivable is nearly zero!

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