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 price of a stock will go down, and profits from any downward movement. The practice is risky, inviting unlimited losses while only providing 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 SandRidge Energy (NYSE: SD), with a current short interest of 7.23%. That's pretty high, but let's see how it compares to other companies in its 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 SandRidge Energy's immediate health, we looked at its current ratio, which simply divides its current assets by its current liabilities. The more assets a company has -- cash, inventory, and accounts receivable, among others -- the more easily it should be able to pay off its obligations in times of financial distress.

SandRidge Energy's ratio in this category is a bit shaky, currently standing at 0.67. We look for current ratios greater than 1, meaning that a company could use its current assets to immediately fund liabilities, if it had to. Just remember that such situations are rare, and that companies can also raise money with other assets if need be. It's best to dig into SandRidge Energy's filings to see whether the company faces any short-term liquidity challenges.


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

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 expenditures that are 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 expenditure costs over a given period of time. In the last twelve months, SandRidge Energy's cash flow has been -$192 million while their earnings were -$449 million.

SandRidge Energy's free cash flow has outperformed its earnings on average. That's generally a good sign that shows the company has been more conservative with its accounting and isn't using sleight-of-hand tricks to overstate its earnings potential.


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

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 to its estimated growth rate. We compared SandRidge Energy's expected P/E ratio of the next 12 months relative to its 5-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, SandRidge Energy currently trades at PEG ratio of 2.08.

Company

Forward P/E

5-Year Growth Estimate %

5-Year PEG Ratio

SandRidge Energy

20.84

10

2.08

Continental Resources (NYSE: CLR)

23.35

11

2.12

Ultra Petroleum (NYSE: UPL)

14.56

22

0.66

Range Resources (NYSE: RRC)

42.93

10

4.29

Forest Oil (NYSE: FST)

12.87

6.25

2.06

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

With a PEG ratio greater than 1.5, short interest is likely targeting SandRidge Energy on account of its significant P/E premium relative to its growth potential.

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 leading 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.

Jeremy Phillips does not own shares of the companies mentioned. Amazon.com is a Stock Advisor recommendation. Try any of our Foolish newsletter services, free for 30 days. The Motley Fool has a disclosure policy.