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 Sigma Designs (Nasdaq: SIGM), with a current short interest of 18.4%. 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. Sigma's short interest is well above that of its peers, indicating investors smell something fishy with its current value.

When evaluating short candidates, start by assessing their near-term financial health. To check on Sigma Designs' 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.

Sigma Designs' ratio in this category is solid, at 5.3. We look for a current ratio greater than 1:


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.

Sigma Designs' free cash flow tailed earnings in 2008, but has since caught up and actually moved ahead. The company's recent cash flow outperformance is largely thanks to dwindling inventories. While these inventory gains may seem temporary, Sigma managed to also slash its accounts receivable last quarter at a time when they're building across the semiconductor industry. There doesn't appear to be any major disconnect between earnings and cash flow currently.


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 Sigma Designs'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, Sigma Designs currently trades at PEG ratio of 0.6.

Company

Forward P/E

5-Year Growth Estimate %

5-Year PEG Ratio

Sigma Designs

9.9

16

0.6

Atheros Communications (Nasdaq: ATHR)

10.3

20

0.5

Broadcom (Nasdaq: BRCM)

12.6

16

0.8

Conexant Systems (Nasdaq: CNXT)

6.3

20

0.3

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

With a PEG ratio of less than 1, Sigma Designs looks attractively valued relative to its expected growth. The company also boasts a balance sheet that's stuffed with cash. It seems that short investors have latched on to Sigma in part because of the company's smaller status in the IPTV chip market relative to their larger peers and massive earnings drop-off since 2008.

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. Sigma Designs is a Motley Fool Rule Breakers selection. Atheros Communications is a Motley Fool Hidden Gems pick. The Fool owns shares of Atheros Communications. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.