What happened

On Tuesday, an earnings beat from educational software company Chegg (Nasdaq: CHGG) the previous evening somehow managed to spark a sell-off across the educational stocks sector, sending language learning company Duolingo (Nasdaq: DUOL) down 10%, costing Chegg rival Pearson (NYSE: PSO) nearly 15% of its market capitalization, and crashing Chegg itself for a 48.5% loss. Chegg warned investors of the impact ChatGPT was having on its business.

On Wednesday, however, it's (mostly) good news for these stocks. After Bank of America called the damage to Pearson stock in particular "overly harsh," that stock had gained 11% by 2 p.m. Wednesday, while Chegg was chugging 13% higher. So far, only Duolingo is being left in the lurch -- down 3%.  

So what

So what unnerved education stock investors yesterday, and how has this changed today?

Despite beating consensus forecasts for both sales and earnings in Q1, Chegg CEO Dan Rosensweig highlighted "a significant spike in student interest" in using free ChatGPT to prepare for end-of-semester exams -- as an alternative to using Chegg's own paid products -- as a headwind to future sales growth. This worry caused Chegg to give second-quarter guidance below Wall Street estimates, and investors quickly concluded that growth might slow even further in outlying quarters as the artificial intelligence (AI) capabilities of ChatGPT and its peers improve.  

What investors may have missed in Monday's warning, however, is that (1) while ChatGPT may be drawing off some potential future sales, Chegg says its retention rates among existing customers are still "very strong;" and that (2) rather than taking on ChatGPT as a competitor, Chegg is "embracing it aggressively and immediately" with a new CheggMate AI-assisted product developed in cooperation with ChatGPT's creator, OpenAI.

What's more, according to Rosensweig, "CheggMate will lead to an increase in the size of the market we serve and strengthen our relationship with our users, while reducing content costs."

And that actually sounds kind of bullish for Chegg -- especially now that its stock is nearly 50% cheaper.

Now what

At a valuation of just 8 times free cash flow, and less than 5 times earnings under generally accepted accounting principles (GAAP) after its sell-off and rebound, Chegg stock has to look attractive to any investor who believes that Wall Street's 25% long-term earnings growth rate estimate for the stock is anywhere near correct. What's more, if an investor is tempted to jump into Pearson stock today based on BofA's say-so, well, it's worth pointing out that according to data from S&P Global Market Intelligence, Pearson's P/E ratio is currently roughly 5 times that of Chegg, while its forward growth rate is less than half as strong.

As for Duolingo, seeing as Duo is unprofitable where both Chegg and Pearson are earning money, I'm inclined to think there's more reason to sell that stock than buy it. It is worth pointing out, however, that just like Chegg, Duolingo says it is allying with OpenAI and building GPT-4 into some of its premium language learning offerings. In contrast to both Chegg and Duo, Pearson seems still to be more in a denial stage, dismissing ChatGPT as a threat and arguing its business is "ChatGPT-proof."    

Time will tell if that's true. For now, I suspect investors are best advised to build some margin of safety into their bets, and if you want to do that, then buying Chegg stock at 5x earnings seems a pretty obvious way to go.