Why Gear4Music (Holdings) Plc (LON:G4M) May Not Be As Efficient As Its Industry

I am writing today to help inform people who are new to the stock market and want a simplistic look at the return on Gear4Music (Holdings) Plc (LON:G4M) stock.

Gear4Music (Holdings) Plc’s (LON:G4M) most recent return on equity was a substandard 7.34% relative to its industry performance of 12.75% over the past year. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into G4M’s past performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of G4M’s returns. Check out our latest analysis for Gear4Music (Holdings)

What you must know about ROE

Return on Equity (ROE) is a measure of Gear4Music (Holdings)’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Investors that are diversifying their portfolio based on industry may want to maximise their return in the Specialty Stores sector by choosing the highest returning stock. But this can be misleading as each company has different costs of equity and also varying debt levels, which could artificially push up ROE whilst accumulating high interest expense.

Return on Equity = Net Profit ÷ Shareholders Equity

Returns are usually compared to costs to measure the efficiency of capital. Gear4Music (Holdings)’s cost of equity is 8.28%. This means Gear4Music (Holdings)’s returns actually do not cover its own cost of equity, with a discrepancy of -0.94%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates in return. ROE can be broken down into three different ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:

Dupont Formula

ROE = profit margin × asset turnover × financial leverage

ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)

ROE = annual net profit ÷ shareholders’ equity

AIM:G4M Last Perf July 1st 18
AIM:G4M Last Perf July 1st 18

Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Gear4Music (Holdings) can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can assess whether Gear4Music (Holdings) is fuelling ROE by excessively raising debt. Ideally, Gear4Music (Holdings) should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. The most recent ratio is 45.17%, which is sensible and indicates Gear4Music (Holdings) has not taken on too much leverage. Thus, we can conclude its current ROE is generated from its capacity to increase profit without a large debt burden.

AIM:G4M Historical Debt July 1st 18
AIM:G4M Historical Debt July 1st 18

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Gear4Music (Holdings)’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Gear4Music (Holdings)’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.

For Gear4Music (Holdings), I’ve put together three essential aspects you should further research:

  1. Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
  2. Valuation: What is Gear4Music (Holdings) worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether Gear4Music (Holdings) is currently mispriced by the market.
  3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Gear4Music (Holdings)? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!