Will MEMC Electronic Materials Shorts Get Burned?

At Fool.com, we believe in buying great companies for the long term. However, not every company commands a fair price, and many trade for far more than they're actually worth.

In these situations, investors actually have a chance to benefit from a stock's plunge. When shorting a stock, an investor bets that the price of it will go down and profits from any move downward. The practice is risky, inviting unlimited losses while providing only limited upside. However, shorting wildly overvalued companies can also help balance your portfolio against the wild market swings we've seen in previous years.

To find shorting candidates, we screened for stocks with a high percentage of their publicly traded shares sold short. One such stock is MEMC Electronic Materials (NYSE: WFR), with a short interest of 10.86%. That's pretty high, but let's sees how it compares with other companies from its part of the semiconductor industry:

Source: Capital IQ, a division of Standard & Poor's.

We consider short interest greater than 5% to be a warning sign. While plenty of great companies can carry high short interest, that red flag is your invitation to dig for troubling information that the company's buyers might be missing.

When evaluating short candidates, start by assessing their near-term financial health. To check on MEMC Electronic Materials' immediate health, we looked at its current ratio, which simply divides a company's current assets by its current liabilities. The more assets a company has -- cash, inventory, and accounts receivable, among other things -- the more easily it should be able to pay off its obligations in times of financial distress.

MEMC Electronic Materials' ratio in this category is solid, at 2.14. We look for a current ratio greater than 1.0, and MEMC Electronic Materials has consistently exceeded this level over time:

Source: Capital IQ. LTM = Latest 12 months.

Once we've assessed a company's short-term financial health, next we determine whether it's overstating its earnings. Earnings are meant to show a smoothed-out picture of a company's profit potential over time. However, they're prone to various assumptions and manipulations. Companies can aggressively recognize revenue, or show high earnings even while they pour excessive amounts of cash into capital spending that is slowly accounted for over time.

For this reason, it's best to compare free cash flow to earnings. Free cash flow accounts for the actual cash flowing out of or into a business, and then subtracts out actual capital spending costs over a given period of time. In the latest 12 months, MEMC Electronic Materials' cash flow has been minus $368 million while its earnings were minus $68 million.

MEMC Electronic Materials' free cash flow has consistently trailed earnings. In this case, it's a good idea to open up company filings and explore what's causing this cash flow lag. If free cash flow is showing a consistent trend of underperforming earnings, that could mean the company is overvalued according to its stated earnings. Or it might be recognizing earnings too aggressively, which could lead to free cash flow declines.

Source: Capital IQ.

One last consideration for shorting a company is valuation. Excellent companies often trade for prices that aren't justified by their business's long-term outlook. Think back to the dot-com bubble: While technology companies like Amazon.com would eventually produce large profits, at the time, they lacked business models and future earnings streams to justify their mammoth market capitalizations.

The PEG ratio is a simple measure of whether a company is excessively valued. It compares a company's P/E ratio with its estimated growth rate. We compared MEMC Electronic Materials' expected P/E ratio for the next 12 months relative to its five-year estimated growth rate. As an investor, you'd look for companies trading at P/Es less than their growth rate. As seen in the table below, MEMC Electronic Materials trades at a PEG ratio of 0.79.

Source: Capital IQ.

With a PEG ratio of less than 1.0, MEMC Electronic Materials looks attractively valued relative to its expected growth. Anyone shorting the stock probably has other areas of concern.

The long road to superior shorting
Identifying good short candidates requires diligent research. More importantly, you've got to know where to dig into a company's financial statements. While the measures we showed above are a great start in searching for shorting candidates, red flags like accelerating revenue recognition, aggressive acquisitions to hide underlying financial weakness, and changes in reporting methods can only be spotted by carefully analyzing the notes companies bury deep in their filings.

Finding these opportunities requires skill, but you can do it. That's why John Del Vecchio, CFA, a forensic accountant and The Motley Fool's shorting specialist, put together a detailed report that shows you how to spot five serious red flags that can help you detect time bombs in your portfolio and lead you to the next big short. You can get the entire report free by clicking here or by entering your email address in the box below.