Should Investors Be Concerned Over Chegg Inc.’s Valuation?

Chegg Inc. (CHGG -3.81%) shares are up over 92% year to date, which provides investors an excellent opportunity to pause and ponder the company's valuation.

In this segment of The Motley Fool's Industry Focus podcast, we continue our discussion on Chegg, and discuss both valuation concerns and the caveats of operating within the education industry.

A full transcript follows the video.

This video was recorded on Sept. 19, 2017.

Vincent Shen: Before we close out on Chegg and move on to another really interesting company that I've actually been following for some time and I'm very excited to talk about, I actually wanted to get a take on any concerns that you might have, Asit. I'll share some of my own as well, in terms of the valuation, and also any potential challenges for this company. Just from what I've seen, the stock has doubled year to date. It's more than tripled from its 2016 lows. It's currently trading at about $14.50 a share. Valuation wise, that puts it at over 6x sales, and almost 80x free cash flow, because it is not yet profitable.

With that in mind, the bottom line is strengthening. Again, it's strengthening pretty quickly with the help of the digital transition -- 2017 guidance from management, for example, for their adjusted EBITDA, was $41 million, versus 2016, that figure was just $21 million, so doubling in the space of a year. But the main concern that I've had ties to comments that management made about how Chegg Tutors is potentially going to become the biggest part of the company in the distant future. They basically alluded to the idea that schools are underinvesting in resources like office hours for students, so Chegg can essentially fill the gap with those affordable, $0.40 per minute tutoring sessions at any time of day and potentially any language to help students learn. But to me, the company talks about Chegg Study, its writing tools, how it's an initial fixed cost, it's insignificant but it scales up very well over time. In this case, the more tutors you need, that's much more of a variable cost that will not scale as well for the company. So that's just something I was watching. Anything that you'd like to call attention to as well for people who are following the company?

Asit Sharma: Obviously, profitability is always one. It's hard to value a company which is losing money. You have to go to other ratios. What's the price to sales? You have to strip away the book loss according to generally accepted accounting principles, and look at EBITDA, which you mentioned. So it's always harder until the company becomes profitable to determine how it should be valued relative to its peers. That's one problem with Chegg. We tend to be long-term holders, as Foolish investors. I'm not sure if we have a recommendation on Chegg, and I'm not advising people to rush out and buy this company. But the longer your holding period, the easier it is to absorb some potential troughs as a company starts becoming profitable and the price adjusts to the valuation.

I will just say, on the concern you have, Vince, I share that concern in the sense that education is a cyclical business. That is, higher education, certification programs, graduate schools, when the economy dips, enrollments decrease. And as school gets more expensive, it's not a given that people will continually enroll in schools at this linearly growing rate. And that's sort of an assumption that underlines Chegg's optimism that, for example, with these study services or tutoring services, they're going to grow because academic institutions are under investing in office hours, etc. Well, if enrollment drops, that's a pressure on the demand for the tutoring services. If you're not in school, you're not going to be buying the tutoring services. So, we've seen in the past, cycles where education is roaring to life, and it seems like many of the stocks that you and I discussed for this show are having great years. So that's one concern with the valuation. Always remember that education is tied to the economy at large. When trades are flourishing because manufacturing is up, or services businesses are booming, also higher education tends to lift as well. But when we are in a recession, the opposite initially occurs until people start realizing that, one way or another, they have to get trained and tack on a degree or two to make money again. So it can be rocky in this industry, and I do share some of your uncertainty regarding the potential valuation of all the companies that are in this sector.