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 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 Under Armour , with a current short interest of 16.5%. 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.

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

Under Armour's ratio in this category is solid, at 3.8. We look for a current ratio greater than 1.0: For this reason, it's best to compare free cash flow with 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, Under Armour's cash flow has been $75.92 million while its earnings were $52.06 million.

Under Armour'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. In Under Armour's case, the company had large inventory swings back in 2007 that caused cash flow to badly lag earnings. However, in recent quarters the situation has reversed and changing inventories have either been neutral or added to earnings. 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 Under Armour'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, Under Armour trades at a PEG ratio of 1.6.

With a PEG ratio greater than 1.5, short interest is likely targeting Under Armour on account of its significant P/E premium relative to its growth potential.

Jeremy Phillips does not own shares of the companies mentioned. Amazon.com is a Stock Advisor recommendation. Under Armour is a Motley Fool Rule Breakers pick and a Motley Fool Hidden Gems recommendation. The Fool owns shares of Under Armour. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.
[null, null, {"document_url": "https://www.fool.com/investing/high-growth/2010/08/27/will-under-armour-shorts-get-burned.aspx", "unformatted_src": "https://g.fool.com/img/editorial/UAShortInterest1.jpg", "src": "https://g.fool.com/img/editorial/UAShortInterest1.jpg", "formatted_filename": "UAShortInterest"}, null, {"document_url": "https://www.fool.com/investing/high-growth/2010/08/27/will-under-armour-shorts-get-burned.aspx", "unformatted_src": "https://g.fool.com/img/editorial/UACurrentRatio.jpg", "src": "https://g.fool.com/img/editorial/UACurrentRatio.jpg", "formatted_filename": "UACurrentRatio"}, null, {"document_url": "https://www.fool.com/investing/high-growth/2010/08/27/will-under-armour-shorts-get-burned.aspx", "unformatted_src": "https://g.fool.com/img/editorial/UAFCFEarnings.jpg", "src": "https://g.fool.com/img/editorial/UAFCFEarnings.jpg", "formatted_filename": "UAFCFEarnings"}, null, null, null, null, null, null]