Most readers would already be aware that Gear4music (Holdings)'s (LON:G4M) stock increased significantly by 31% over the past week. However, we decided to pay attention to the company's fundamentals which don't appear to give a clear sign about the company's financial health. Particularly, we will be paying attention to Gear4music (Holdings)'s ROE today.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Put another way, it reveals the company's success at turning shareholder investments into profits.

Check out our latest analysis for Gear4music (Holdings)

How Do You Calculate Return On Equity?

ROE can be calculated by using the formula:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Gear4music (Holdings) is:

1.7% = UK￡651k ÷ UK￡38m (Based on the trailing twelve months to March 2024).

The 'return' is the income the business earned over the last year. Another way to think of that is that for every ￡1 worth of equity, the company was able to earn ￡0.02 in profit.

Why Is ROE Important For Earnings Growth?

We have already established that ROE serves as an efficient profit-generating gauge for a company's future earnings. Depending on how much of these profits the company reinvests or "retains", and how effectively it does so, we are then able to assess a company’s earnings growth potential. Assuming all else is equal, companies that have both a higher return on equity and higher profit retention are usually the ones that have a higher growth rate when compared to companies that don't have the same features.

A Side By Side comparison of Gear4music (Holdings)'s Earnings Growth And 1.7% ROE

As you can see, Gear4music (Holdings)'s ROE looks pretty weak. Even when compared to the industry average of 12%, the ROE figure is pretty disappointing. Therefore, it might not be wrong to say that the five year net income decline of 37% seen by Gear4music (Holdings) was possibly a result of it having a lower ROE. We reckon that there could also be other factors at play here. For instance, the company has a very high payout ratio, or is faced with competitive pressures.

That being said, we compared Gear4music (Holdings)'s performance with the industry and were concerned when we found that while the company has shrunk its earnings, the industry has grown its earnings at a rate of 13% in the same 5-year period.

Earnings growth is a huge factor in stock valuation. What investors need to determine next is if the expected earnings growth, or the lack of it, is already built into the share price. By doing so, they will have an idea if the stock is headed into clear blue waters or if swampy waters await. Has the market priced in the future outlook for G4M? You can find out in our latest intrinsic value infographic research report.