Valuations 101: How to Use the Graham Equation to Analyze Short Squeezes

Are you someone who likes to follow the investing trends of sophisticated investors?

For a look at what big money traders think about a stock, short-selling data is a great resource. Because short-selling requires borrowing, a trader must meet several requirements (including background checks) to engage in short-selling. Thus short-sellers are generally more sophisticated than the average investor.

Because short-selling is an investment technique for profiting from a stock's price decline, increased short-selling of a stock indicates a more bearish outlook. Conversely, decreased short-selling indicates short-sellers are bullish on the company.

We wanted to take a look at some of the names receiving bullish sentiment from short-sellers -- meaning they believe there is more upside to the names than downside.

But we also wanted to add the perspective of the respected investor Benjamin Graham. Graham was a former mentor to Warren Buffett, whom he taught at Columbia Business School, and is considered the "godfather of value investing."

Graham created an equation to help search for potentially undervalued stocks, and identifies what is known as the "Graham number," or the maximum fair value for a stock. Any stock trading at a significant discount to this number is considered by the equation to be undervalued.

The Graham Number only requires two data points: current earnings per share and current book value per share. The Graham Number = Square Root of (22.5) x (TTM Earnings per Share) x (MRQ Book Value per Share). This equation assumes that a stock is overvalued if P/E is over 15 or P/BV is over 1.5.

So we screened a universe of stocks with market caps over $300 million and identified those that have experienced significant levels of short covering. Then we applied the graham equation and took only the names deemed most undervalued.

We list the remaining companies below, sorted by potential upside, along with relevant data below.

Short-sellers seem to these names have the potential to grow, and Grahams equation backs up that theory. But do you think these stocks are being undervalued by the market? Use this list as a starting off point for your own analysis. (Click here to access free, interactive tools to analyze these ideas.)

List compiled by Eben Esterhuizen, CFA:

1. MEMC Electronic Materials (NYS: WFR) : Engages in the development, manufacture, and sale of silicon wafers for the semiconductor industry worldwide. Shares shorted have decreased from 24.55M to 21.91M over the last month, a decrease which represents about 1.15% of the company's float of 229.51M shares. Diluted TTM earnings per share at 0.31, and a MRQ book value per share value at 10.33, implies a Graham Number fair value = sqrt(22.5*0.31*10.33) = $8.49. Based on the stock's price at $6.18, this implies a potential upside of 37.35% from current levels.

2. Cytec Industries (NYS: CYT) : Engages in developing, manufacturing, and selling chemical products worldwide. Shares shorted have decreased from 2.29M to 991.76K over the last month, a decrease which represents about 2.95% of the company's float of 44.00M shares. Diluted TTM earnings per share at 4.31, and a MRQ book value per share value at 37.4, implies a Graham Number fair value = sqrt(22.5*4.31*37.4) = $60.22. Based on the stock's price at $45.21, this implies a potential upside of 33.21% from current levels.

3. NuVasive (NAS: NUVA) : Engages in the design, development, and marketing of minimally disruptive surgical products and procedures for the spine. Shares shorted have decreased from 7.17M to 6.09M over the last month, a decrease which represents about 2.72% of the company's float of 39.72M shares. Diluted TTM earnings per share at 1.85, and a MRQ book value per share value at 12.82, implies a Graham Number fair value = sqrt(22.5*1.85*12.82) = $23.10. Based on the stock's price at $17.86, this implies a potential upside of 29.34% from current levels.

4. SAIC (NYS: SAI) : Offers scientific, engineering, systems integration, and technical services to various branches of the U.S. military and U.S. government. Shares shorted have decreased from 12.39M to 9.60M over the last month, a decrease which represents about 1.03% of the company's float of 270.56M shares. Diluted TTM earnings per share at 1.69, and a MRQ book value per share value at 7.09, implies a Graham Number fair value = sqrt(22.5*1.69*7.09) = $16.42. Based on the stock's price at $12.7, this implies a potential upside of 29.29% from current levels.

5. Fairchild Semiconductor International (NYS: FCS) : Designs, develops, manufactures, and sells power analog, power discrete, and non-power semiconductor solutions worldwide. Shares shorted have decreased from 5.24M to 3.92M over the last month, a decrease which represents about 1.05% of the company's float of 126.03M shares. Diluted TTM earnings per share at 1.35, and a MRQ book value per share value at 10.27, implies a Graham Number fair value = sqrt(22.5*1.35*10.27) = $17.6

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.

At the time thisarticle was published 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.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.