Analyst's Toolkit: Palm Not Worth the Risk

Analyst's Toolkit is a weekly feature that assesses stocks, bonds and funds by using measures that can give different perspectives on valuation. Come back every Wednesday for fresh insights into analyzing securities.

Palm(PALM Quote) has been buzzing from the release of its newest smart phone, the Pre, sending the company's stock into overdrive despite a putrid balance sheet and a heavy reliance on private equity funding.

With a quarter-to-date return of more than 60%, besting the S&P 500 index by a whopping 45 percentage points, it's easy to be excited by Palm. However, with the help of the Sharpe ratio, it's clear that Palm's stellar performance doesn't adequately compensate for risks.

The Sharpe ratio, named for its creator, William Sharpe, is a tool that allows analysts and investors to judge the amount of compensation a stock pays for its volatility.

The Sharpe ratio can be written as follows:

Sharpe ratio = (return on the asset - risk-free rate)/standard deviation of the share price.

The output of this formula shows the excess return that an investor can expect for each unit of risk. Of course, a higher expected excess return per unit of risk is better than a smaller expected return.

Calculating the ratio can be more intensive than other financial gauges since it's not derived from readily available financial figures. The 10-year Treasury note's rate can be used as the risk-free rate and the asset return is simply calculated as a gain or loss over a certain time period.

The calculation of standard deviation, however, requires the use of a computer, or a lot of scratch paper and time. The input required to find the standard deviation is a string of period returns. For the computations below, monthly returns over a five-year period were used.