It's said you can't judge a book by its cover. By the same token, you definitely shouldn't judge a stock by its earnings release.

QuinStreet (Nasdaq: QNST) jumped by as much as 14% in intraday trading on Thursday, after reporting first-quarter earnings. The stock finished the day up 10% with an "adjusted," or non-GAAP, P/E ratio of 18.9.

The P/E ratio seems pretty reasonable based on the information in the press release, which highlighted revenue growth of 19% year over year and adjusted EPS of $0.25, also up 19%. The release said management continues to expect that the company will "grow revenue an average of 15-20% per year, even at this scale, for as far as the eye can see, reflective of our large footprint and uniquely powerful competitive advantages." Wow, that sounds like a great company.

Revenue grew by 26% in the company's Education vertical. QuinStreet's education clients are for-profit companies such as DeVry (NYSE: DV), which accounted for 19% of 2009 sales. Declining enrollment, the threat of more government regulation, and accusations of failing to adequately train students are challenging for-profit educators such as DeVry, Apollo Group (Nasdaq: APOL), Universal Technical Institute (NYSE: UTI), and Corinthian Colleges (Nasdaq: COCO). Those challenges appear to be working in QuinStreet's favor. 

What's not to like?
As required by law, the earnings release mentioned that GAAP earnings per share were $0.13, a little more than half of "adjusted" EPS. Adjusted EPS is also known as "earnings before bad stuff." In QuinStreet's case, the bad stuff includes stock-option expensing and amortization of intangible assets, neither of which is likely to decrease significantly anytime soon.  

Wall Street likes "adjusted" earnings. It's so much easier to pump stocks when you ignore the bad stuff. To be fair, sometimes adjusting earnings is a good thing. It can increase transparency, facilitate comparisons with peers, and improve visibility. IBM's (NYSE: IBM) recent move in this direction is a good example.

More often than not, however, earnings adjustments just create good headlines and make the stock look cheaper. Based on QuinStreet's reported EPS -- the official earnings that comply with generally accepted accounting principles -- QuinStreet has a P/E ratio of 36. That's almost twice the "adjusted" P/E ratio. It's also a rich P/E … and it's especially tough to justify, with adjusted EPS forecasted to grow by only 3% during the next 12 months.

Revenue growth is slowing
Despite management's bullish comment about "average" revenue growth of 15% to 20% annually "for as far as the eye can see," at least one analyst begs to differ. Stifel Nicolaus believes that "the momentum in education is likely to continue for at least another few quarters before normalizing to a 10-15 percent growth rate."

Revenue growth is already slowing, from 36% in fiscal 2009 to 29% in fiscal 2010. It was 27% as recently as the fourth calendar quarter of 2010, before falling to 19% in the first quarter of 2011.

Fiscal 2008 revenue grew by a mere 15%. That was before the global recession sent scores of people to for-profit education companies … and also before the government started cracking down on those companies. With employment arguably improving, demand for for-profit education could continue declining.  

Perhaps management used the word "average" in its revenue-growth forecast of 15% to 20% to give itself wiggle room if growth falls short of that range.

Whatever happened to economies of scale?
Top-line growth of 19% in the most recent quarter failed to drive the margin expansion that one might expect (see table). Comparing it with the year-ago quarter to remove seasonal effects, we can see that neither gross nor operating margin improved.

QuinStreet

Quarter Ended March 2010

Quarter Ended March 2011

Gross Margin

27.0%

27.0%
Operating Margin

11.2%

11.2%
Pre-Tax Margin

11.2%

11.2%
Net Margin

5.8%

5.9%

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

According to analysts at JPMorgan Chase, the Education vertical's revenue growth of 26% was primarily driven by a continued increase in demand from existing clients. If QuinStreet can't expand margins by growing revenue with existing clients, EPS is not likely to grow any faster than revenue. 

Foolish takeaway
A rich P/E, slowing revenue growth, stagnant margins, and a massive gap between GAAP and adjusted earnings are all red flags for QuinStreet investors. But wait -- there's more! Investors who ignore these warning signals may get an unprofitable education. To help you get more educated about QuinStreet and other stocks, The Motley Fool recently introduced a free feature called My Watchlist. You can get up-to-date news and analysis by adding companies to your own personalized watchlist right now: