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 its price will go down and profits from any move down. 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 Rackspace Hosting (NYSE: RAX), with short interest of 25%. 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 Rackspace Hosting'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.

Rackspace Hosting's ratio in this category is solid, at 1.3. 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, Rackspace Hosting's cash flow was $81.53 million while its earnings were $37.65 million.


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

Rackspace Hosting's 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. Rackspace Hosting, a hosted service provider, has to spend a good amount to keep upgrading and buying new servers. This capital expenditures burn has been a key reason why net income has trailed free cash flow. In recent quarters, depreciation charges have caught up to capital spending, so net income and free cash flow may be more in line in the future.

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 Rackspace Hosting's 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, Rackspace Hosting currently trades at a PEG ratio of 1.8.

Company

Forward P/E

5-Year Growth Estimate %

5-Year PEG Ratio

Rackspace

44.2

25

1.8

Akamai Technologies (Nasdaq: AKAM)

34.0

15

2.3

Computer Sciences (NYSE: CSC)

7.7

8

1.0

Digital River (Nasdaq: DRIV)

30.7

13.5

2.3

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

With a PEG ratio greater than 1.5, short interest is likely targeting Rackspace Hosting on account of its significant P/E premium relative to its growth potential. Also, the company operates in a highly competitive niche. Aside from offering services that compete with the companies above, companies like Microsoft and Amazon have aggressively rolled out their own platforms for hosting. That increased competition from larger competitors is probably contributing to Rackspace Hosting's 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 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 and Microsoft is an Inside Value selection. Akamai Technologies and Rackspace Hosting are Rule Breakers recommendations. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Microsoft. Try any of our Foolish newsletter services free for 30 days. 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. The Fool has a disclosure policy.