Analyst's Toolkit: Palm Not Worth the Risk

Palm's stock isn't worth the risk that investors take, according to a gauge known as the Sharpe ratio.
Author:
Publish date:

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)

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.

Image placeholder title

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.

The following table shows the inputs and resulting Sharpe ratio for Palm, the S&P 500,

General Electric

(GE) - Get Report

and

Apple

(AAPL) - Get Report

for their quarter-to-date returns.

Note: Standard deviation, or "S.D." above, is usually represented by the Greek character sigma.

The table shows both the incredible returns and the huge variability for Palm. With a Sharpe ratio of 2.35, Palm easily surpasses Apple in terms of excess return per unit of risk. However, when compared with the S&P 500 as a whole, Palm lags behind.

From the view that the standard deviation in a stock price is a measure of the risk for the security, the table suggests that investors in Palm aren't being adequately compensated for the risk they assume.

According to the Sharpe ratio, Palm investors could be earning superior risk-adjusted returns by investing in General Electric, which offers extremely low volatility and a dividend of nearly 4% beyond the return displayed in the table.

Some Palm investors may argue that the big return is worth the decreased compensation for additional risk. However, there are stocks that offer superior returns that

do

adequately compensate for risk.

One such holding is

Bank of America

(BAC) - Get Report

, which has soared 96% in the quarter-to-date period, with a standard deviation slightly above 17%, leading to a Sharpe ratio of 5.4, far higher than Palm's 2.35.

While Palm has been gaining at a fantastic pace over the past few months, its risk-adjusted returns are still not attractive enough to justify an investment over other companies. Until its balance sheet improves, Palm will remain a gamble with terrible odds.

TSC Ratings provides exclusive stock, ETF and mutual fund ratings and commentary based on award-winning, proprietary tools. Its "safety first" approach to investing aims to reduce risk while seeking solid outperformance on a total return basis.

Prior to joining TheStreet.com Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level II CFA candidate.