What Gap Does With Its Cash

In the quest to find great investments, most investors focus on earnings to gauge a company's financial strength. This is a good start, but earnings can be misleading and incomplete. To get a clearer understanding of a company's ability to earn money and reward you, the shareholder, it's often better to focus on cash flow. In this series, we tear apart a company's cash flow statement to see how much money is truly being earned, and more importantly, what management is doing with that cash.

Step on up, Gap (NYSE: GPS  ) .

The first step in analyzing cash flow is to look at net income. Gap's net income over the past five years has been impressive:

�	2011*	2010	2009	2008	2007
Normalized Net Income	$1.0 billion	$1.2 billion	$1.1 billion	$1.0 billion	$0.9 billion

Source: S&P Capital IQ.
*12 months ended Oct. 30.

Next, we add back in a few non-cash expenses like the depreciation of assets, and adjust net income for changes in inventory, accounts receivable, and accounts payable -- changes in cash levels that reflect a company either paying its bills, or being paid by customers. This yields a figure called cash from operating activities -- the amount of cash a company generates from doing everyday business.

From there, we subtract capital expenditures, or the amount a company spends acquiring or fixing physical assets. This yields one version of a figure called free cash flow, or the true amount of cash a company has left over for its investors after doing business:

�	2011*	2010	2009	2008	2007
Free Cash Flow	$0.9 billion	$1.2 billion	$1.6 billion	$1.0 billion	$1.4 billion

Source: S&P Capital IQ.
*12 months ended Oct. 30.

Now we know how much cash Gap is really pulling in each year. Next question: What is it doing with that cash?

There are two ways a company can use free cash flow to directly reward shareholders: dividends and share repurchases. Cash not returned to shareholders can either be stashed in the bank, used to invest in other companies, or used to pay off debt.

Here's how much Gap has returned to shareholders in recent years:

�	2011*	2010	2009	2008	2007
Dividends	$0.2 billion	$0.3 billion	$0.2 billion	$0.2 billion	$0.3 billion
Share Repurchases	$2.6 billion	$2.0 billion	$0.5 billion	$0.7 billion	$1.7 billion
Total Returned to Shareholders	$2.8 billion	$2.3 billion	$0.7 billion	$0.9 billion	$2.0 billion

Source: S&P Capital IQ.
*12 months ended Oct. 30.

The company has repurchased a decent amount of its own stock. That's caused shares outstanding to fall:

�	2011*	2010	2009	2008	2007
Shares Outstanding (Millions)	558	636	694	716	791

Source: S&P Capital IQ.
*12 months ended Oct. 30.

Now, companies tend to be fairly poor at repurchasing their own shares, buying feverishly when shares are expensive and backing away when they're cheap. Does Gap fall into this trap? Let's take a look:

Source: S&P Capital IQ.

Source: S&P Capital IQ.

There was a pullback in share repurchases in 2009, when shares were dirt cheap -- that was unfortunate -- but for the most part Gap's management has a good track record with share buybacks, repurchasing a large amount of stock in the past several years as shares traded at low valuations, causing its share outstanding to fall dramatically. These buybacks have no doubt been a good deal for shareholders.

Finally, I like to look at how dividends have added to total shareholder returns:

Source: S&P Capital IQ.

Source: S&P Capital IQ.

Over the past five years, Gap shares returned 25%, which drops to 13% without dividends -- not a bad boost to top off already decent returns.

To gauge how well a company is doing, keep an eye on the cash. How much a company earns is not as important as how much cash is actually coming in the door, and how much cash is coming in the door isn't as important as what management actually does with that cash. Remember, you, the shareholder, own the company. Are you happy with the way management has used Gap's cash? Sound off in the comment section below.

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