Investing 101: 3 Undervalued Stocks With Increased Short Covering

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Interested in companies that appear undervalued? The following not only appear undervalued by levered free cash flow but have received some bullish signals from short-sellers.

For this list we searched for names with market caps over $300 million. We then narrowed the list down to those undervalued by the ratio levered free cash flow to enterprise value and kept only the names over 5%.

Lastly, we chose the names that showed a decrease in short-selling -- or short covering -- a signal short-sellers think these names will rise in value.

Here's more information on the terms "levered free cash flow," "enterprise value," and "short covering." Our final list is detailed below.

Levered free cash flow is a calculation of the amount of cash that a company holds after it has paid taxes, repayments on its debts, and any expenditures to maintain or expand business (Capital expenditure or CapEx). In other words, levered free cash flow is the money that the business can use to grow and pay dividends to shareholders.

Enterprise value is an alternative measure of a company's value (instead of using market cap). Theoretically, it is the cost of taking over a company, calculated as market cap plus debt and liabilities minus cash. For example, if Company A were to buy 100% of Company B, it would need to buy all the outstanding shares, the value of which is the market cap. Company A would then be stuck with any debts and liabilities that Company B had. But Company A would also get all of the cash that Company B had in the bank, which would help pay off the debts, etc.

Because cash is an important asset for a company (it allows them to buy new machines, hire more people, etc.) and because it is hard to lie about how much cash a company has, a company that holds more cash is seen to be of better value.

The levered free cash flow to enterprise value ratio (LFCF/EV) is one method of measuring the value of a company. The more free cash a company has relative to its enterprise value (a high ratio), the cheaper the company appears. 

Short-selling is an investment technique that allows an investor to make money when the value of a stock falls. Short-sellers, however, lose money when the share price rises.

When a company sees a decrease in shares shorted, it indicates that short-sellers are less pessimistic on the company. They become eager to rid themselves of their short positions. This is referred to as "short covering."

In general: When there is an INCREASE in short-selling, short-sellers seem to think the names will DROP in value. When there is a DECREASE in short-selling, short-sellers seem to think the names will RISE in value

Short-sellers seem to think these names have more upside potential than downside. Do you agree? (Click here to access free, interactive tools to analyze these ideas.)

1. Veeco Instruments (NAS: VECO) : Designs, manufactures, and markets equipment to make high brightness light emitting diodes (HB LEDs), solar panels, hard-disk drives, and other devices. Shares shorted have decreased from 11.87M to 10.96M over the last month, a decrease which represents about 2.58% of the company's float of 35.33M shares. Levered free cash flow at $100.64M vs. enterprise value at $529.40M (implies a LFCF/EV ratio at 19.01%).

2. Conns (NAS: CONN) : Operates as a specialty retailer of home appliances, consumer electronics, home office equipment, lawn and garden products, mattresses, and furniture in the United States. Shares shorted have decreased from 3.75M to 3.51M over the last month, a decrease which represents about 1.68% of the company's float of 14.25M shares. Levered free cash flow at $83.40M vs. enterprise value at $517.23M (implies a LFCF/EV ratio at 16.12%).

3. Western Refining (NYS: WNR) : Operates as an independent crude oil refiner and marketer of refined products in Texas, Arizona, New Mexico, Utah, Colorado, and the Mid-Atlantic region. Shares shorted have decreased from 16.92M to 16.31M over the last month, a decrease which represents about 1.14% of the company's float of 53.73M shares. Levered free cash flow at $340.44M vs. enterprise value at $2.13B (implies a LFCF/EV ratio at 15.98%).

Interactive Chart: Press Play to compare changes in analyst ratings over the last two years for the stocks mentioned above. Analyst ratings sourced from Zacks Investment Research.


Kapitall's Eben Esterhuizen and Rebecca Lipman do not own any of the shares mentioned above. Data sourced from Yahoo! Finance.

At the time this article was published The Motley Fool owns shares of Western Refining. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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