Tech-Bubble Finder: Analyst's Toolkit - TheStreet

BOSTON (TheStreet) -- Technology stocks have risen faster than at any time since the Internet bubble was inflating in the late '90s. (The 10-year anniversary of D-Day for tech stocks is two months away.)

Palm

(PALM)

,

Microsoft

(MSFT) - Get Report

and

Intel

(INTC) - Get Report

have have posted gains of about twice the

S&P 500's

31% increase in the past 12 months, while

Apple

(AAPL) - Get Report

and

Amazon

(AMZN) - Get Report

have more than doubled.

Sirius XM

(SIRI) - Get Report

has jumped six-fold after trading around 10 cents a share a year ago. Those returns have many investors excited, but it's important to temper expectations by accounting for the risk of fast-growing companies.

The risk-adjusted return is more important than the simple return. Many investors are speculators, investing for total return with little consideration of risk in a portfolio. For those investors, who have the willingness and ability to absorb large movements, adjusting for risk may seem pointless, but for most of us, we need to consider risk to meet liquidity needs and long-term goals.

The Sharpe ratio is one of the best ways to account for risk. The formula, which takes the expected return of an asset minus the risk-free rate over the standard deviation of the asset's return, shows how much excess return the investment will generate per unit of standard deviation, a measure of risk.

Simply put, an investment with more excess return per unit of risk will compensate the investor better for assuming that risk. Investors picking investments with high Sharpe ratios will have better risk-adjusted returns.

Consider the table above, detailing the standard deviation, beta value, expected return and Sharpe ratio of technology companies.

Even though Apple and Intel provide expected returns, based on the capital asset pricing model, that are smaller than some of the other companies' included in the analysis, they have higher Sharpe ratios due to less volatile share prices. This translates into a smaller possibility of massive losses due to a tighter distribution of returns.

Palm and Sirius, on the other hand, offer much smaller Sharpe ratios, implying that investors aren't compensated for risk as much. Despite having an expected return of almost 22%, the most in the group, Sirius' Sharpe ratio is only 2.04 because the large standard deviation of 8.9% makes the return volatile.

To provide context, it's important to know that the standard deviation of a security's return is based on the range of potential returns. The most probable return of Sirius will lie either 8.9% above or below the expected return, so between 31% and 13%. Investors speculating on the stock should find this range to be appealing since it suggests Sirius has a fair chance of gaining nearly 31%. Risk-adverse investors, on the other hand, would be wise to avoid a stock with this much uncertainty.

-- Reported by David MacDougall in Boston.

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 III CFA candidate.