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 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 Dynamic Materials (Nasdaq: BOOM), with a current short interest of 5.2%. That's pretty high, but let's see how it compares to other companies it competes with.



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. In Dynamic Materials' case, it's difficult to find peers for a one-to-one comparison. While Schlumberger and Halliburton are seen as the main competition to Dynamic Materials' DYNAenergetics explosives (both companies produce their own needs and buy from other suppliers), they're large oil and gas equipment companies, while Dynamic Materials is limited to more niche areas.

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

Dynamic Materials' ratio in this category is solid, at 1.9. 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 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 12 months, Dynamic Materials' free cash flow has been $23.73 million while its earnings were $4.74 million.

Dynamic Materials' free cash flow has outperformed its earnings recently. 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. One encouraging sign for the company, while earnings have cratered toward zero recently, cash flow has been on the rise. Capital expenditures have been cut (probably an unsustainable situation), while accounts receivable have declined, providing a boost to operating cash flow.



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

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 Dynamic Materials' 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, Dynamic Materials currently trades at PEG ratio of 1.7.

Company

Forward P/E

5-Year Growth Estimate %

5-Year PEG Ratio

Dynamic Materials

22.0

13.0

1.7

Halliburton (NYSE: HAL)

12.9

8.0

1.6

Schlumberger Limited (NYSE: SLB)

16.4

13.1

1.3

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

With a PEG ratio greater than 1.5, short interest is likely targeting Dynamic Materials on account of its significant P/E premium relative to its growth potential, as well as its steep revenue falloff 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. The Fool owns shares of Dynamic Materials, which is a Motley Fool Hidden Gems selection. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.