Capital Allocation Trends At Gear4music (Holdings) (LON:G4M) Aren't Ideal

Simply Wall St
·3 min read

What trends should we look for it we want to identify stocks that can multiply in value over the long term? Ideally, a business will show two trends; firstly a growing return on capital employed (ROCE) and secondly, an increasing amount of capital employed. Put simply, these types of businesses are compounding machines, meaning they are continually reinvesting their earnings at ever-higher rates of return. In light of that, when we looked at Gear4music (Holdings) (LON:G4M) and its ROCE trend, we weren't exactly thrilled.

Return On Capital Employed (ROCE): What is it?

If you haven't worked with ROCE before, it measures the 'return' (pre-tax profit) a company generates from capital employed in its business. To calculate this metric for Gear4music (Holdings), this is the formula:

Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)

0.079 = UK£6.1m ÷ (UK£94m - UK£17m) (Based on the trailing twelve months to March 2022).

Thus, Gear4music (Holdings) has an ROCE of 7.9%. Ultimately, that's a low return and it under-performs the Specialty Retail industry average of 14%.

Check out our latest analysis for Gear4music (Holdings)

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Above you can see how the current ROCE for Gear4music (Holdings) compares to its prior returns on capital, but there's only so much you can tell from the past. If you'd like to see what analysts are forecasting going forward, you should check out our free report for Gear4music (Holdings).

So How Is Gear4music (Holdings)'s ROCE Trending?

When we looked at the ROCE trend at Gear4music (Holdings), we didn't gain much confidence. To be more specific, ROCE has fallen from 15% over the last five years. On the other hand, the company has been employing more capital without a corresponding improvement in sales in the last year, which could suggest these investments are longer term plays. It's worth keeping an eye on the company's earnings from here on to see if these investments do end up contributing to the bottom line.

On a side note, Gear4music (Holdings) has done well to pay down its current liabilities to 18% of total assets. That could partly explain why the ROCE has dropped. Effectively this means their suppliers or short-term creditors are funding less of the business, which reduces some elements of risk. Some would claim this reduces the business' efficiency at generating ROCE since it is now funding more of the operations with its own money.

What We Can Learn From Gear4music (Holdings)'s ROCE

Bringing it all together, while we're somewhat encouraged by Gear4music (Holdings)'s reinvestment in its own business, we're aware that returns are shrinking. It seems that investors have little hope of these trends getting any better and that may have partly contributed to the stock collapsing 75% in the last five years. All in all, the inherent trends aren't typical of multi-baggers, so if that's what you're after, we think you might have more luck elsewhere.

Gear4music (Holdings) does have some risks, we noticed 5 warning signs (and 2 which make us uncomfortable) we think you should know about.

While Gear4music (Holdings) isn't earning the highest return, check out this free list of companies that are earning high returns on equity with solid balance sheets.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.