Time to Short Solarfun Power Holdings?

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 its price will go down and profits from any downward movement. 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 Solarfun Power Holdings (Nasdaq: SOLF), with a current short interest of 26.6%. That's pretty high, but let's see how it compares with 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 Solarfun Power Holdings' 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.

Solarfun Power Holdings' ratio in this category is solid, at 2.1. We look for a current ratio greater than 1.0:

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 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 expenditure costs over a given period of time. In the past 12 months, Solarfun Power Holdings' cash flow has been zero dollars while its earnings were $87.47 million.

Solarfun Power Holdings' free cash flow has trailed earnings on average. 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 in the future. In Solarfun's case, consistent rising inventory, accounts receivable, and advances to suppliers are the culprits in the cash flow lag. These are definitely areas to keep a wary eye on.

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 Solarfun Power Holdings' expected P/E ratio of 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, Solarfun Power Holdings trades at a PEG ratio of 0.5.

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

With a PEG ratio of less than 1.0, Solarfun Power Holdings looks attractively valued relative to its expected growth. Investors shorting the stock are either looking at other areas of concern, or feel analyst growth estimates have overstated the company's potential. The coming year is looking pretty friendly to many solar companies, so investors may feel Solarfun's long-term prospects aren't up to analysts' estimates, or question the value of the company's earnings based on the consistently trailing cash flows seen above.

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.