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Is Gear4music Holdings plc the next ASOS plc?

Sales rose by 55% to £24.4m at Gear4music Holdings (LSE: G4M) during the four months to 31 December. Full-year profits are now expected to be “ahead of the increased expectations signalled at the half year stage”.

According to today’s update, sales are up by 63% so far in the current financial year, compared to the same period last year.

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Since its AIM flotation in June 2016, Gear4music’s shares have risen by 261%. The group’s sales were just £12.3m in 2012/13, but are expected to reach £56m this year. Profitability is also improving.

I’m starting to wonder if this stock could deliver the kind of 1,000%-plus returns enjoyed by early investors in ASOS (LSE: ASC).

This is why I’m excited

Today’s update shows that Gear4music’s European expansion has unleashed massive sales growth. Sales to Europe rose by 129% to £9.4m during the final four months of last year, while UK sales rose by 29% to £15m.

What’s exciting is that the group’s sales could have much further to rise. In October, Gear4music claimed a 4% share of the UK market. This is a market that’s historically been very fragmented, with large numbers of small independent retailers both online and offline.

I believe there’s scope for Gear4music to increase its market share significantly from current levels.

What could go wrong?

The main risk for investors is that the company will fall short of expectations in some way.

Before today, Gear4music was expected to generate earnings of 7.7p per share this year, rising by 48% to 11.4p in 2017/18. This puts the stock on a 2016/17 forecast P/E of 65, falling to a P/E of 44 for next year.

That’s a demanding valuation, but I don’t think it’s as expensive as it seems. Gear4music has a PEG ratio (price/earnings growth) of just 1.4. A PEG ratio of less than one is generally considered cheap for a growth stock, so I’d say these shares are probably priced about right at the moment.

A lesson from ASOS

Over at ASOS, earnings are expected to rise by more than 20% per year over the next couple of years. But what interests me is that the market is valuing this business on a 2016/17 P/E ratio of 67, falling to 54 in 2017/18.

This puts ASOS on a similar valuation to Gear4music, even though earnings growth is expected to be much slower. As a result of this premium valuation, ASOS now has a PEG ratio of 2.6 for the current year. This looks too expensive to me.

However, it’s worth remembering that ASOS is a proven business with significant scale. Revenue is expected to reach £1.8bn this year, compared to just £56m at Gear4music. ASOS also has around £2 per share of net cash, and strong free cash flow. Gear4music is still investing in expanding its facilities and has very little surplus cash.

Which stock should you buy?

I’d find it very hard to invest in either stock at current levels. But if I was to choose, I’d be tempted to make a small investment in Gear4music. This fast-growing business seems to have the potential to double or triple in size from its current levels.

I can’t see that happening with ASOS, which looks overpriced to me.

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Roland Head has no position in any shares mentioned. The Motley Fool UK owns shares of and has recommended ASOS. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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