Analysis of The Gap, Inc.

Report by Valanium Analysts: Kozo Hiratani (khira@mit.edu), Tokuya Ikeguchi (iket@mit.edu),

Bancha Serngadichaivit (bancha@mit.edu), Pornprom Vongpivat (pornprom@mit.edu)

Investment Recommendation: MARKET PERFORMER December 3, 2001

GPS – NYSE (11/29/01) $13.61 EPS Forecast

52 Week Range $11.12 - $34.98 1999A 2000A 2001F 2002F
EPS $1.32 $1.03 $0.54 $0.64
Revenue (trailing twelve months) $14.3B
Market Capitalization $11.7B Ratios Firm Mean of Competitors
Share Outstanding 862.4M Forward P/E 25.20 16.88
Forward PEG 1.44 0.97
Dividend Yield 0.60% M/B 3.84 2.94
Avg. Daily Trading Volume (3 mo) 5.53M P/S 0.83 0.91

Book Value per Share (11/03/01) $3.54 Valuation Predictions

Return of Equity 9.99% Actual Current Price $13.61
Return on Assets 3.91% Target Price $13.96
Est. 5 Years EPS Growth Rate 17.50% P/E Valuation $9.12
PEG Valuation $9.19
Industry Specialty retailing – clothing M/B Valuation $10.39
GPS 6 month stock price movement P/S Valuation $16.50
EBO (Abnormal Earnings) Valuation $16.98
DCF Valuation $14.97

Performance of GPS
Trailing 6 mo 12 mo 24 mo
Return on GPS -53.9% -45.3% -63.9%
Return on S&P 500 -8.7% -14.2% -17.8%
Return on Competitors -24.2% -16.5% -30.6%

• We recommend a rating of market performer on GPS at its current price of $13.61 and have a target
price of $13.96 based on a common range of comparative, EBO and DCF analyses.
• Amongst clothing specialty retailers, GPS has the largest scale and strongest brand awareness but has
the lowest operating margin and highest debt ratio. Relative to general retailers of comparable size,
GPS has both favorable operating margin and debt ratio.
• While GPS has been significantly hurt by the economic slowdown, it has also been making several
improvements this year and into the future in terms of inventory management and space allocation.
• We do not detect any earnings management, hence the quality of GPS’s earnings stated in the
financial reports is sufficiently high and we have confidence in them for the valuations in this report.

Rating System:
BUY: A strong purchase recommendation with above average long-term growth potential.
MARKET OUTPERFORM: A purchase recommendation that is expected to marginally outperform the return of the market.
MARKET PERFORMER: A recommendation to maintain current positions with returns to match that of the market.
SELL: A recommendation to sell the security (or short the security) as it is expected to decrease in price in the medium term.

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Strategic Analysis

Company Background and Business Summary

The Gap, Inc. (“Gap”) is the largest specialty retailer in the United States with revenue of $13.7 billion in
2000, operating stores selling casual apparel, personal care, and other accessories for men, women, and
children under the Gap, Banana Republic, and Old Navy brands. Gap has served as the bridge of fashion
between multiple generations and continues to pursue global brand identity through high-quality growth
initiatives. Gap was founded in 1969, starting with a single store in San Francisco selling Levi’s and
records.

As of August 4, 2001, Gap operated 3,973 stores of 34.4 million square feet in the United States, Canada,
the United Kingdom, France, Germany, and Japan. The company currently employs 166,000 worldwide.
Gap designs virtually all of its products, which in turn are manufactured by independent sources, and
sells them under its brands in the following store formats: Gap (started in 1969), Banana Republic (acquired
in 1983), and Old Navy (started in 1994). Gap also distributes its products through catalogs (Banana
Republic) and online through various Websites, such as www.gap.com, www.gapkids.com,
www.babygap.com, www.bananarepublic.com, and www.oldnavy.com.

Comparison to Competitors

Gap by far dominates clothing specialty retailer sector with sales six times its next largest competitor,
Polo Ralph Lauren. However, Gap has the lowest operating margin (Fig.1) and also possesses the highest
D/E ratio amongst specialty retailers (Fig.2).

Due to Gap’s size, Gap could also be compared to other more general retailers that are of comparable size.
These retailers also sell, among other products, clothing and apparel. In comparison to this group, Gap
has both a favorable operating margin and D/E ratio.

Fig.1 Business Comparison to Competitors

Company Business Description Sales (ttm) Operating
Margin (ttm)
The Gap, Inc. Refer to “Company Background” $14.30B 5.1%
Specialty Retailer Comps
Abercrombie & Fitch Markets men, women, and kids apparel of $1.34B 20.0%
casual, classic sportswear. Targeted consumers
15 to 50 years of age and kids 7 to 14 years old.
American Eagle Outfitters Markets men, women casual apparel, accessories $1.33B 13.0%
and footwear. Targeted consumers between the
ages of 16 and 34.
Ann Taylor Markets women apparel, shoes, accessories, $1.27B 5.2%
career and casual separates, dresses, tops, and
weekend wear.
Pacific Sunwear Markets casual apparel, accessories and $0.66B 7.8%
footwear. Targeted to teens and young adults
Polo Ralph Lauren Markets men, women, kids apparel, home $2.27B 13.6%
appliances, gift items, and fragrance.
General Retailer Comps
J. C. Penney Company, Inc. Operates 3,800 stores and markets $31.80B -2.0%
predominantly family apparel, jewelry, shoes,
accessories and home furnishings.
Sears, Roebuck and Co. Retails multiple product lines in a wide array of $14.60B 2.7%
merchandise and services.
Target Corporation Engaged in general merchandise retailing. $34.20B 5.1%
Note: ttm means trailing twelve months

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Fig.2 Financial Comparison to Competitors
Competitors Market Capitalization Price/Book Debt/Equity
The Gap, Inc. $11.70B 4.29 0.84
Specialty Retailer Comps
Abercrombie & Fitch $2.30B 4.50 0.00
American Eagle Outfitters $1.90B 4.21 0.05
Ann Taylor $0.80B 1.28 0.22
Pacific Sunwear $0.57B 2.49 0.05
Polo Ralph Lauren $2.62B 2.88 0.40
General Retailer Comps
J. C. Penney Company, Inc. $7.14B 1.26 0.90
Sears, Roebuck and Co. $14.60B 2.37 4.19
Target Corporation $12.40B 4.86 0.84
Note: As of 11/29/01

Competitive Advantages

Strong brand awareness – According to market research, the Gap brands have 100% brand awareness in
the United States, and more than 70% of US apparel consumers have been in a Gap or Old Navy store in
past six months. Fifty percent wear Gap or Old Navy merchandise occasionally, if not more frequently.

Regional diversification – The Gap can hedge the macroeconomics factor by the regional diversification.
For example, the sales decline by the macroeconomic recession in Japan has been hedged by bullish
macro economy in United States.

Effective inventory management and sourcing – Due to the economies of scale, Gap has the huge
opportunities of effective inventory management and sourcing. Currently, Gap operates distribution
centers in California, Kentucky, Maryland, Ohio and New York within the United States and in Canada,
England, and the Netherlands outside the United States. Two distribution centers are attributed solely to
fulfill catalog and Internet orders. Gap outsources 100% of its products from 1,100 suppliers worldwide.
Of the merchandise, 80% is produced outside the United States, with China and Hong Kong representing
12% of all goods and 56 other countries for the rest. In 2000, no single supplier had the share of more
than 5% of the company’s purchases.

Potential Risks

Major economic downturn risk – The US economy has been slowing down since March 2001.
Furthermore, the September 11th event has especially affected Gap by pushing down consumer
confidence, which leads to negative affects on earnings.

Risk from competition – Overall apparel prices have been deflationary over the past several years, and
although Gap is not at the high end of the pricing spectrum, Gap competes not only in the
aforementioned specialty retailers but also in the better, moderate, “value-based retailers”, such as Wal-
Mart, Target and Kohl’s. It will spur the competition and lower the apparel pricing. Deflationary prices
place the pressure on Gap to increase sales volume, requiring additional product line extensions and
spaces. It may lead to cause “a drain on capital”.

Trend-mismatching risk – As the competition becomes fierce, retailers try to differentiate their own
products, which lead to the rapid change of product. It will be more difficult to anticipate, identify and
respond effectively to changing consumer demands and fashion trends. Any failure will adversely affect
retail and consumer acceptance of its products and leaves Gap with a substantial amount of unsold
inventory or missed potential growth opportunities.

Cannibalization risk – Gap potentially suffers from cannibalization amongst its own brands: Old Navy,
Banana Republic and Gap.

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Currency and political risk – Because all production is outsourced, factory disruptions could materially
affect production and timely product delivery. With 80% of merchandise sourced overseas, Gap is
subject to social, political and economic risk in each of the countries from which it sources product.
Import restrictions, including the changes in such tariffs and quotas could affect the importation of
apparel and could increase the cost or reduce supply. Merchandise flow could be adversely affected by
political instability and by restrictions in the transfer of funds.

Growth Prospects

To alleviate the decreases of earnings in 2000, lower operating margin in Sep 2001 and aforementioned
risks, Gap has made the following improvements.

Strong inventory management – Gap planned for a further discipline in inventory management to
minimize inventory on a comparative basis. This results in an increase in inventory turnover. Gap is also
constructing three regional distribution centers for Gap and Old Navy Brands. These distribution centers
are strategically located and self-contained with every store now within a one-day drive from one of these
centers.

Real estate and space allocation – Gap has been lowering its square footage growth plans for 2002 and
2003 to 10% from a prior 15%. This will lead to decrease operational expense and capital expenditures for
PPE.

Greater focus on expenses – Gap has been implementing cost-cutting measures, which focuses on
eliminating redundancies. Gap eliminated 1,600 employee positions in June, including 1,040 at
headquarters and Banana Republic field employees, and the elimination of about 560 open positions.
This was a 10% reduction in the workforce from fiscal year end 2000 levels.

Merchandising initiatives – Gap will return to its focus on key items, which lead to improve inventory
turnover and gross margins.

Valuation Analysis

Price Target

Based on our analysis, we estimate Gap is worth $13.96 per share compared to the current market price of
$13.61 per share as of November 29, 2001. Various valuation methods have been employed, namely,
comparables analysis, discounted cash flow analysis, and residual income (EBO) analysis.

Comparables Analysis

We have chosen specialty retailers and general retailers as Gap’s comparables. The specialty retailer
comparables try to capture the aspects of Gap’s business, which is in the specialty retailing of clothing.
General retailers, which are comparable in size to Gap, are chosen to capture the size effects since Gap is
significantly larger than other specialty retailers. Size effects can influence important factors such as
risks, discount rate, and growth rate.

The four methods used are forward P/E valuation, forward PEG valuation, M/B valuation, and P/S
valuation (Fig.3). The comparables valuation of Gap produces a price range from $9.12 to $16.50 per
share. This range encompasses Gap’s market price of $13.61, which indicates that Gap is neither
significantly overvalued nor undervalued. This range is calculated using the simple average of the
comparables and removing any outliers. Specifically, the outlier removed was J. C. Penney in the
calculation of both the forward PEG valuation and the P/S valuation since J. C. Penney’s ratios differed
from the average by a factor of four.

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Fig.3 Comparables Analysis
Forward P/E Valuation 0.54
Company Current price EPS (next year) Forward P/E GAP valuation
$/share $/share $/share
Abercrombie & Fitch 23.39 1.84 12.71 6.86
American Eagle Outfitters 25.26 1.82 13.88 7.49
Ann Taylor 27.06 1.48 18.28 9.87
Pacific Sunwear 17.61 1.04 16.93 9.14
Polo Ralph Lauren 24.00 1.97 12.18 6.58
J. C. Penney 26.30 0.93 28.28 15.27
Sears, Roebuck and Co. 45.99 4.37 10.52 5.68
Target 37.41 1.68 22.27 12.02
Mean 16.88 9.12
GAP 15.19 0.51 29.78 17.50
Forward PEG Valuation 0.54
Company Forward P/E 5-year growth Forward PEG GAP valuation
% $/share
Abercrombie & Fitch 12.71 20.00 0.64 6.01
American Eagle Outfitters 13.88 22.00 0.63 5.96
Ann Taylor 18.28 15.00 1.22 11.52
Pacific Sunwear 16.93 20.00 0.85 8.00
Polo Ralph Lauren 12.18 14.80 0.82 7.78
J. C. Penney 28.28 5.00 5.66 53.45
Sears, Roebuck and Co. 10.52 9.00 1.17 11.05
Target 22.27 15.00 1.48 14.03
Mean 0.97 9.19
GAP 29.78 15.00 1.99 18.76
M/B Valuation 3.54
Company Current price Book value (1) M/B GAP valuation
$/share $/share $/share
Abercrombie & Fitch 23.39 5.13 4.56 16.14
American Eagle Outfitters 25.26 6.29 4.02 14.22
Ann Taylor 27.06 20.93 1.29 4.58
Pacific Sunwear 17.61 6.85 2.57 9.10
Polo Ralph Lauren 24.00 9.24 2.60 9.19
J. C. Penney 26.30 21.70 1.21 4.29
Sears, Roebuck and Co. 45.99 19.00 2.42 8.57
Target 37.41 7.76 4.82 17.07
Mean 2.94 10.39
GAP 15.19 3.54 4.29 15.19
P/S Valuation 16.41
Company Current price Sales (2) P/S GAP valuation
$/share $/share $/share
Abercrombie & Fitch 23.39 12.99 1.80 29.55
American Eagle Outfitters 25.26 18.08 1.40 22.93
Ann Taylor 27.06 40.29 0.67 11.02
Pacific Sunwear 17.61 19.94 0.88 14.49
Polo Ralph Lauren 24.00 23.09 1.04 17.06
J. C. Penney 26.30 112.13 0.23 3.85
Sears, Roebuck and Co. 45.99 124.69 0.37 6.05
Target 37.41 42.71 0.88 14.37
Mean 0.91 16.50
GAP 15.19 16.41 0.93
15.19
Source: yahoo.com
Note: As of 11/29/01
(1) Most recent quarter; (2) Trailing twelve months
Mean calculation excludes outliers
Forward P/E valuation is Forward P/E multiplied by GAP's EPS (next year) of $0.54
Forward PEG valuation is Forward PEG multiplied by GAP's EPS (next year) of $0.54 and 5-year growth of 17.5%
M/B valuation is M/B multiplied by GAP's book value of $3.54
P/S valuation is P/S multiplied by GAP's Sales of $16.41

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Discounted Cash Flow Analysis

We estimate Gap’s future free cash flow and discount them back to find its equity value today. The
resulting DCF valuation of Gap produces a range of prices from $11.42 to $21.65 per share (Fig.4). The
following assumptions are used in our analysis:

• Projected earnings – We assume the average annual sales growth to decrease to 17.5% during the
next five years due to the higher competition and economic recession. Also, we estimate its operating
margin to decrease to 5.1%, which is the current margin of Gap in 2001.

• Projected free cash flow – We decrease Gap’s projected capital expenditure during the next five
years due to its policy not to aggressively expand its store as it did in the past. In terminal year, we
assume a constant growth rate of 7%, which reflects a higher competition and its reduction in capital
expenditure in the long run. In our analysis, we use enterprise free cash flow to estimate Gap’s
enterprise value. We then subtract net debt to find its equity value.

• Weighted average cost of capital (WACC) – We estimate Gap’s cost of equity from the Capital Asset
Pricing Model (CAPM) to be 11.6%. This low number results from a low equity beta of 1.01, which
we estimate from its monthly stock return from the last 60 months. From Gap’s 2000 annual report,
its average after-tax cost of debt is 6.4%. Weighting them with market value of debt and equity, we
estimate Gap’s WACC to be 10.8%.

• Sensitivity analysis – We perform sensitivity analysis on a terminal growth rate and WACC to
estimate a range of a stock price, given that an equity value is sensitive to these assumptions (Fig.4).

Fig.4 Sensitivity Analyses for Discounted Cash Flow Analysis and Residual Income (EBO) Analysis
DCF EBO

Terminal Growth Rate Terminal Growth Rate

6.5% 7.0% 7.5% 9.5% 10.0% 10.5%

10.3% $15.50 $18.11 $21.65 11.1% $18.34 $24.82 $42.10

Cost of equity
WACC

10.8% $13.05 $14.97 $17.46 11.6% $13.86 $16.98 $22.99

11.3% $11.42 $12.95 $14.88 12.1% $10.89 $12.54 $15.23

Residual Income (EBO) Analysis

We estimate Gap’s abnormal earnings, discount them back, and add them to a book value of equity to
find its equity value today. The resulting EBO valuation of Gap produces a range of prices from $10.89 to
$42.10 per share (Fig.4). The following assumptions are used in our analysis:

• Projected earnings – Same as discounted cash flow analysis.

• Projected abnormal earnings – We use a conservative approach to estimate abnormal earnings by

assuming a zero dividend payout ratio due to a dramatic decrease in profits and pressure from
competition in the future. In terminal year, we assume a constant growth rate of 10%, which reflects
a higher competition and its reduction in capital expenditure in the long run.

• Cost of equity – We estimate Gap’s cost of equity from the CAPM to be 11.6%.

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• Sensitivity analysis – We perform sensitivity analysis on a terminal growth rate and cost of equity to
estimate a range of a stock price, given that an equity value is sensitive to these assumptions (Fig.4).

Estimated Stock Price

We estimate the target price by calculating the midpoint of the common price range of the three
aforementioned valuation analyses (Fig.5). Based on the valuation, we expect Gap’s price range to be
from $11.42 to $16.50 per share. Thus, we set the target price at $13.96 per share. This range is in the
neighborhood of the price range of most analyst reports, which further supports the significance of this
analysis.

Fig.5 Valuation Ranges and Price Target

Valuation

Price Target (midpoint): $13.96

Comparables $9.12 $16.50

Discounted Cash Flow $11.42 $21.65

Residual Income (EBO) $10.89 $42.10

0 5 10 15 20 25 30 35 40 45
Per Share Value (in $)

Quality of Earnings Analysis

The quality of Gap’s earnings stated in the financial reports is sufficiently high and we have confidence
on them for the valuation in this report. We cannot find any evidence of manager’s intentional
manipulations and any underlying motivations to misstate earnings or balance sheet items, which we
used in deriving numbers for DCF and multiples valuation analysis. In order to evaluate the degree to
which Gap’s financial statements capture the underlying business reality and the likelihood of managers
exercising their accounting flexibilities, the following four-step analysis was performed.

Accrual Growth Against Sales Growth

Historically, Gap has very small portion of accounts receivables, 0.32% to sales in 1991, 0.33% in 1992 and
0.46% in 1993. However, after 1993, Gap has not recorded any accounts receivables. For the past five
years, sales have increased by 26% per year on average while the increase in accounts receivables have
been zero (Fig.6).

Gap has no accounts receivables because their sales are made with cash, personal checks or credit cards
such as VISA, MasterCard, and American Express. Thus, there is no threat in the unsubstantiated
increase in sales through the increase in accruals.

Volatility of Cash Flow Against Accounting Income

If the ratio of volatility of operation income before depreciation to volatility of cash flow from operations
is less than one, it implies that management might manipulate accounting information to smoothen

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earning through accruals. In this case, the firm might be misrepresenting the risk of the firm beyond
what is reasonable.

However, Gap’s ratio is 138%, which indicates that that Gap’s cash flow is less volatile than its operation
income (Fig.6). Gap is thus not likely to be managing earnings. In comparison to the ratios of its
competitors, Gap’s ratio is not significantly different from the average.

EPS Growth Against Net Income Growth

In 2000, the change in net income and the change in basic EPS are almost the same (Fig.6). Both indicate a
significant drop in net income and EPS. Through 1996 to 1999, changes of EPS were much smaller or
negative compared to that of net income. This can be attributed to changes in the number of shares
outstanding. Gap issued new common stocks aggressively from 1996 to 1999. This resulted in the
dilution of EPS, while net income grew.

If the change in the ratios were of the opposite direction, for example, the change in EPS is positive while
that in net income is negative, then there is reason to believe that EPS is managed to look good.
However, for Gap, reported EPS is not managed since the percent change in net income is always greater
or equal to the percent change in EPS.

Changes in Accounting Policy and Key Personnel

From the 2000 annual report, we found that Gap adopted a new accounting policy related to sales
recognition. Under the new rule, Gap records all amounts billed to a customer in a sale transaction
related to shipping and handling as net sales rather than operating expenses. Although this change
would decrease gross margins, it does not affect earnings.

The auditor of Gap, Deloitte & Touche, has not been changed during the past five years. In addition, we
did not find any significant turnovers of key executives or lawyers in fiscal year 2000. Therefore, there is
no explicit or implicit evidence of conflicts from the company, its auditors, and related parties that may
suggest earnings management.

Fig.6 Quality of Earnings Analysis

Figures in $ million except EPS 1996 1997 1998 1999 2000 Average STD
Accrual growth against sales growth
Sales 5,284 6,508 9,054 11,635 13,673 9,231 3,484
Accounts receivables 0 0 0 0 0 0 0
% Growth in sales 20% 23% 39% 29% 18% 26%
% Growth in accounts receivables 0% 0% 0% 0% 0% 0%

Volatility of cash flow against accounting income

Operating inc before dep 921 1,097 1,638 2,231 2,082 1,594 580
Cash flow from operations ("CFO") 835 845 1,394 1,478 1,291 1,169 307
Volatitily of operating inc before dep 36%
Volatility of CFO 26%
Vol (operating inc) / Vol (CFO) 138%

EPS growth against net income growth

Net income 453 534 825 1,127 878 763 273
Basic EPS 1.60 1.35 1.43 1.32 1.03 1.35 0.21
% Change in net income 28% 18% 54% 37% -22% 23%
% Change in basic EPS -57% -16% 6% -8% -22% -19%
Note: Volatility is calculated from STD / Average

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Appendix 1 -- Projected financial statements of Gap, Inc.

Income statement ($million) 1996 1997 1998 1999 2000 2001F 2002F 2003F 2004F 2005F
Net sales 5,284.4 6,507.8 9,054.5 11,635.4 13,673.5 16,066.3 18,877.9 22,181.6 26,063.3 30,624.4
Cost of goods sold 3,093.7 3,776.0 5,013.5 6,339.1 8,009.1 10,266.4 12,063.0 14,174.0 16,654.5 19,569.0
Depreciation expense 191.5 245.6 304.8 436.2 590.4 642.7 755.1 887.3 1,042.5 1,225.0
Operating expenses 1,270.1 1,635.0 2,403.4 3,043.4 3,629.3 4,337.9 5,097.0 5,989.0 7,037.1 8,268.6
Earnings before interests & taxes (EBIT) 729.1 851.3 1,332.9 1,816.7 1,444.8 819.4 962.8 1,131.3 1,329.2 1,561.8
Net interest expenses (19.5) (3.0) 13.6 31.8 62.9 80.3 94.4 110.9 130.3 153.1
Earnings before taxes 748.5 854.2 1,319.3 1,784.9 1,381.9 739.1 868.4 1,020.4 1,198.9 1,408.7
Income taxes 295.7 320.3 494.7 657.9 504.4 269.8 317.0 372.4 437.6 514.2
Net income 452.9 533.9 824.5 1,127.1 877.5 469.3 551.4 647.9 761.3 894.5
Average number of shares (Basic) 283.3 396.2 576.0 853.8 849.8 862.4 862.4 862.4 862.4 862.4
Earnings per share (Basic) 1.60 1.35 1.43 1.32 1.03 0.54 0.64 0.75 0.88 1.04
Net sales growth 20.2% 23.2% 39.1% 28.5% 17.5% 17.5% 17.5% 17.5% 17.5% 17.5%
COGS/Net sales 58.5% 58.0% 55.4% 54.5% 58.6% 63.9% 63.9% 63.9% 63.9% 63.9%
Depreciation/Net sales 3.6% 3.8% 3.4% 3.7% 4.3% 4.0% 4.0% 4.0% 4.0% 4.0%
Operating expenses/Net sales 24.0% 25.1% 26.5% 26.2% 26.5% 27.0% 27.0% 27.0% 27.0% 27.0%
Net interest expenses/Net sales -0.4% 0.0% 0.2% 0.3% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5%
Implied tax rate 39.5% 37.5% 37.5% 36.9% 36.5% 36.5% 36.5% 36.5% 36.5% 36.5%
Net income growth 27.9% 17.9% 54.4% 36.7% -22.1% -46.5% 17.5% 17.5% 17.5% 17.5%
Capital expenditure/Net sales 7.0% 7.2% 8.8% 10.6% 13.6% 10.0% 8.0% 6.0% 4.0% 4.0%
Balance sheet ($million) 1996 1997 1998 1999 2000 2001F 2002F 2003F 2004F 2005F
Assets
Cash & equivalents 621.3 913.2 565.3 450.4 408.8 480.3 564.4 663.2 779.2 1,668.8
Inventory 578.8 733.2 1,056.4 1,462.0 1,904.2 2,237.4 2,628.9 3,089.0 3,629.6 4,264.7
Other current assets 129.2 184.6 250.1 285.4 335.1 393.7 462.7 543.6 638.7 750.5
Total current assets 1,329.3 1,830.9 1,871.8 2,197.8 2,648.1 3,111.5 3,656.0 4,295.8 5,047.5 6,684.0
Net property and equipment 1,135.7 1,365.3 1,876.4 2,715.3 4,007.7 4,971.7 5,726.8 6,170.4 6,170.4 6,170.4
Other assets 162.0 141.3 215.7 275.7 357.2 419.7 493.1 579.4 680.8 800.0
Total assets 2,626.9 3,337.5 3,963.9 5,188.8 7,012.9 8,502.8 9,875.9 11,045.6 11,898.7 13,654.4

Liabilities & shareholders' equity

Liabilities
Note payable 40.1 84.8 90.7 169.0 779.9 1,222.2 1,364.3 1,087.6 241.3 0.0
Current portion of long-term debt 0.0 0.0 0.0 0.0 250.0 293.8 345.2 405.6 476.5 559.9
Account payable 351.8 417.0 684.1 805.9 1,067.2 1,254.0 1,473.4 1,731.3 2,034.2 2,390.2
Other current liabilities 291.3 406.2 655.8 751.7 684.2 803.9 944.6 1,109.9 1,304.2 1,532.4
Income taxes payable 91.8 83.6 122.5 26.3 17.8 20.9 24.6 28.9 34.0 39.9
Total current liabilities 774.9 991.6 1,553.1 1,752.9 2,799.1 3,594.8 4,152.1 4,363.3 4,090.2 4,522.5
Long term debt 0.0 496.0 496.5 784.9 780.2 916.8 1,077.2 1,265.7 1,487.2 1,747.5
Other liabilities 197.6 265.9 340.7 417.9 505.3 593.7 697.6 819.7 963.1 1,131.7
Total liabilities 972.5 1,753.5 2,390.2 2,955.7 4,084.7 5,105.3 5,926.9 6,448.7 6,540.6 7,401.7
Shareholders' equity
Paid-in common shares 15.9 22.0 33.3 50.4 47.0 47.0 47.0 47.0 47.0 47.0
Additional paid-in capital 394.2 279.5 334.0 669.5 295.0 295.0 295.0 295.0 295.0 295.0
Retained earnings 1,933.2 2,377.5 3,108.8 4,172.8 4,974.8 5,444.1 5,995.5 6,643.4 7,404.7 8,299.3
Accumulated other losses 0.0 0.0 0.0 (6.8) (20.2) (20.2) (20.2) (20.2) (20.2) (20.2)
Deferred compensation 0.0 0.0 0.0 (23.2) (12.2) (12.2) (12.2) (12.2) (12.2) (12.2)
Treasure stock at cost (688.8) (1,095.0) (1,902.4) (2,629.7) (2,356.1) (2,356.1) (2,356.1) (2,356.1) (2,356.1) (2,356.1)
Total shareholders' equity 1,654.5 1,584.0 1,573.7 2,233.0 2,928.2 3,397.5 3,949.0 4,596.9 5,358.2 6,252.7
Total liabilities & shareholders' equity 2,626.9 3,337.5 3,963.9 5,188.8 7,012.9 8,502.8 9,875.9 11,045.6 11,898.7 13,654.4
Checking 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Appendix 2 -- Valuation analysis of Gap, Inc.
DCF valuation ($million) 2000 2001F 2002F 2003F 2004F 2005F Weighted average cost of capital
Enterprise valuation Beta equity 1.01
Net income 469.3 551.4 647.9 761.3 894.5 Risk free rate 3.5%
Depreciation 642.7 755.1 887.3 1,042.5 1,225.0 Market risk premium 8.0%
Capital expenditure (1,858.7) (1,606.6) (1,510.2) (1,330.9) (1,042.5) (1,225.0) Cost of equity 11.6%
Change in current assets (391.9) (460.4) (541.0) (635.7) (747.0) After-tax cost of debt 6.4%
Change in current liabilities 309.6 363.8 427.5 502.3 590.2 WACC 10.8%
After-tax net interest expenses 51.0 59.9 70.4 82.8 97.2
Free cash flow to enterprise (525.9) (240.4) 161.2 710.6 835.0 Terminal growth
Terminal value 23,243.2 DCF valuation 7.0%
Discount factor 0.90 0.81 0.73 0.66 0.60 EBO valuation 10.0%
PV of cash flow (474.5) (195.7) 118.3 470.8 14,390.1
Enterprise value 14,309.1 Debt to market equity ratio
Net debt 1,401.4 Debt value 2,170.1
Equity value 12,907.7 Market equity value 13,100.2
Average number of shares 862.4 15,270.2
Expected stock price 14.97
Sensitivity analysis for DCF valuation (expected stock price)
EBO valuation ($million) 2000 2001F 2002F 2003F 2004F 2005F
Equity valuation Terminal growth
Net income 469.3 551.4 647.9 761.3 894.5 6.5% 7.0% 7.5%
Book value of equity 2,928.2 3,397.5 3,949.0 4,596.9 5,358.2 6,252.7 10.3% 15.50 18.11 21.65
Expected normal earnings 339.1 393.4 457.3 532.3 620.5 WACC 10.8% 13.05 14.97 17.46
Abnormal earnings 130.2 158.0 190.6 229.0 274.1 11.3% 11.42 12.95 14.88
Abnormal earnings growth 21.34% 20.66% 20.12% 19.68%
Terminal value 19,080.1 Sensitivity analysis for EBO valuation (expected stock price)
Discount factor 0.90 0.80 0.72 0.65 0.58
PV of abnormal earnings 116.7 126.9 137.2 147.7 11,190.3 Terminal growth
Equity value 14,647.1 9.5% 10.0% 10.5%
Average number of shares 862.4 Note: No dividend payment 11.1% 18.34 24.82 42.10
Expected stock price 16.98 Cost of equity 11.6% 13.86 16.98 22.99
12.1% 10.89 12.54 15.23