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When short sellers cover a stock they signal a belief that shares have more upside than downside to price in. Couple this with other indicators that shares are trading below fair value, and you're looking at an interesting list. Intrigued? We create that stock list here.

We began with a universe of stocks that have seen significant decreases in shares shorted month-over month, where the decrease represents at least 2% of the company's float. We then looked for names that may be undervalued using two metrics:

Levered Free Cash Flow/ Enterprise Value (LFCF/EV) above 15%. This ratio gives us the money that the business can use to grow and pay dividends to shareholders. Levered free cash flow is the free cash flow after deducting interest payments on outstanding debt. Enterprise value is the sum of the firm's value from all ownership sources: market cap, outstanding debt, and preferred shares.

When companies have ratios of levered free cash flow/enterprise value in excess of 10%, it may indicate that the company as a whole is being undervalued.

Undervalued relative to EPS trends. Based on the theoretical assumption that if P/E is equal to a constant K, growth in EPS estimates should be matched by proportionate growth in price. When they don't match up, a mispricing may have occurred. We screened for those exhibiting this mismatch between changes in EPS estimate and price.

For an interactive version of this chart, click on the image below. Analyst ratings sourced from Zacks Investment Research.

Short sellers seem to think these potentially undervalued stocks have upside to price in. Do you think these stocks should be trading higher?

Use this list and supporting data as a starting point for your own analysis.

1. Netflix, Inc. (NASDAQ:NFLX): Provides subscription based Internet services for TV shows and movies in the United States and internationally.

  • Market cap at $10.55B, most recent closing price at $188.37.
  • The EPS estimate for the company's current year increased from 1.13 to 1.29 over the last 30 days, an increase of 14.16%. This increase came during a time when the stock price changed by 1.5% (from 181.962 to 184.7 over the last 30 days).
  • Shares shorted have decreased from 9.72M to 8.07M over the last month, a decrease which represents about 3.36% of the company's float of 49.18M shares. Days to cover ratio at 1.52 days.
  • Levered free cash flow at $1.70B vs. enterprise value at $10.29B (implies a LFCF/EV ratio at 16.52%).
  • More BULLISH Signals: Hedge Funds are buying up shares: Net institutional purchases in the current quarter at 3.6M shares, which represents about 7.32% of the company's float of 49.18M shares.

2. Sanderson Farms, Inc. (NASDAQ:SAFM): Engages in the production, processing, marketing, and distribution of fresh, frozen, processed, and prepared chicken products.

  • Market cap at $1.24B, most recent closing price at $53.96.
  • The EPS estimate for the company's current year increased from 2.52 to 2.86 over the last 30 days, an increase of 13.49%. This increase came during a time when the stock price changed by 4.84% (from 51.27 to 53.75 over the last 30 days).
  • Shares shorted have decreased from 1.89M to 1.48M over the last month, a decrease which represents about 2.02% of the company's float of 20.27M shares. Days to cover ratio at 5.93 days.
  • Levered free cash flow at $172.35M vs. enterprise value at $1.33B (implies a LFCF/EV ratio at 12.96%).
  • More BULLISH signals: Positive accounts receivable trends: Revenue grew by 15.05% during the most recent quarter ($595.76M vs. $517.83M y/y). Accounts receivable grew by -43.41% during the same time period ($108.26M vs. $191.29M y/y). Receivables, as a percentage of current assets, decreased from 43.42% to 27.18% during the most recent quarter (comparing 3 months ending 2013-01-31 to 3 months ending 2012-01-31).

3. Take-Two Interactive Software Inc. (NASDAQ:TTWO): Develops, and distributes interactive entertainment software, hardware, and accessories worldwide.

  • Market cap at $1.46B, most recent closing price at $15.93.
  • The EPS estimate for the company's current year increased from 0.17 to 0.18 over the last 30 days, an increase of 5.88%. This increase came during a time when the stock price changed by 4.19% (from 14.8 to 15.42 over the last 30 days).
  • Shares shorted have decreased from 18.42M to 17.12M over the last month, a decrease which represents about 2.13% of the company's float of 61.02M shares. Days to cover ratio at 8.3 days.
  • Levered free cash flow at $250.21M vs. enterprise value at $1.14B (implies a LFCF/EV ratio at 21.95%).
  • More BULLISH signals: Insiders are buying shares: Over the last six months, insiders were net buyers of 3,191,593 shares, which represents about 5.23% of the company's 61.02M share

*Insider, EPS and Short data sourced from Yahoo! Finance. Institutional data sourced from Fidelity, accounting data from Google Finance. All other data sourced from Finviz.

Source: Short Sellers Are Covering 3 Stocks Undervalued By EPS Trends And Cash Flow