At The Motley Fool, 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 Amedisys (Nasdaq: AMED), with a current short interest of 25.7%. That's pretty high, but let's see how this hospice provider companies to other companies within the health care space.


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 yellow flag is your invitation to dig for troubling information that the company's buyers might be missing. As you can see from the chart above, Amedisys has short interest clearly above its peers. A large contingent of investors feels its prospects are worse than any general trends which might be affecting the health care industry.

When evaluating short candidates, start by assessing their near-term financial health. To check on Amedisys' immediate health, we looked at its current ratio, which simply divides its current assets by its current liabilities. The more short-term 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.

Amedisys' ratio in this category is solid, at 1.2. 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 prone to various assumptions and manipulations. Companies can aggressively recognize revenue or stuff the channel by offering overly favorable terms or any number of other tricks.

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 general, you'd like to see this above reported net income. In the past 12 months, Amedisys' cash flow has been $197.58 million, while its earnings were $142.58 million.


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

Amedisys' 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. Overall, the company has consistently shown rising free cash flow while also managing to grow revenues and earnings. However, there are concerns about the company's overall accounting practices. In 2008, research came out that questioned the company's reserve accounting practices. More recently, the Senate Finance Committee launched an investigation into whether the company deliberately boosted the number of home visits to boost higher Medicare repayments.

One last consideration for shorting a company is valuation. Excellent candidates often trade for prices that aren't justified by their business's long-term outlook. Think back to the dot-com bubble: Many technology companies lacked business models and future earnings streams to justify their mammoth market capitalizations. When that was eventually broadly realized, prices crashed back to earth. Depending on when the position was opened, shorts could have made a lot of money.

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 Amedisys' 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 expected growth rate. As seen in the table below, Amedisys currently trades at PEG ratio of 0.4.

Company

Forward P/E

5-Year Growth Estimate %

5-Year PEG Ratio

Amedisys

6.3

14.2

0.39

Almost Family (Nasdaq: AFAM)

8.8

17.5

0.44

Gentiva Health Services (Nasdaq: GTIV)

7.7

15.0

0.50

LHC Group (Nasdaq: LHCG)

8.0

15.5

0.48

Source: Yahoo! Finance.

With a PEG ratio of less than 1, Amedisys 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. In this case, it appears the continuing questions around Amedisys' accounting procedures and Medicare billing practices are key drivers in the continuing high short interest.

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.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Jeremy Phillips does not own shares of the companies mentioned. The Fool owns shares of Almost Family. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.