Invest With the Cool Kids

Through the end of August, go back to school with The Motley Fool. You'll find more educational book reviews, stock analysis, and financial advice here.

Welcome back, class. I hope you enjoyed your weekend. (I spent mine grading term papers.)

I also hope you remembered to hit the books, because if you recall from our previous lessons, "School's In for the Summer" and "Too Cool for School," today is the big day -- final exams for our nine for-profit educators. Take out your No. 2 pencils and calculators, boot up your laptops, and log on to Yahoo! Finance so we can get to number-crunching. This will be an open-book test.

Who gets the A?
When considering which of the for-profit educators offers the best investment potential, you can approach the question from several perspectives. Let's look at the raw data first, and then see if we can't draw some conclusions about it.

The winner of the "most popular" vote here is clearly Apollo Group (NASDAQ:APOL) -- its tremendous market capitalization shows that most investors expect the owner of the ubiquitous "University of Phoenix Online" brand will continue to dominate this industry in the future.

Then again, the kid voted "most popular" in high school isn't always also voted "most likely to succeed." In that contest, you might want to back Strayer (NASDAQ:STRA). This Motley Fool Hidden Gems Watch List stock boasts the highest profit margin of the bunch -- better even than Apollo's superb 18% net margin.

A third way to pick a winner is to recognize that although market dominance and profitability are nice, it's possible to overpay for quality. To invoke a phrase popular here at The Motley Fool, "Valuation Matters." If you agree that price is an object when choosing your stocks, you might be inclined to add Career Education (NASDAQ:CECO) to your portfolio. The firm's trailing price-to-earnings ratio is the lowest of the group, yet it sports a fairly healthy growth rate of 15%. Remember, though, that Career Education is currently the only one of these nine companies still under active federal investigation regarding its marketing practices. The company has good reason for being the cheapest of the bunch.

If the threat of federal prosecution gives you the willies, but you're nonetheless intrigued by Career Education's price, you might consider adding blue-collar educators UTI (NYSE:UTI) and Lincoln (NASDAQ:LINC) to your shopping list instead. They're apparently not much more expensive than Career Education, according to their P/E ratios, and if you wait patiently, the market just might offer you a chance to buy them even cheaper. Again, UTI has the Hidden Gems seal of approval -- something Career Education can't yet boast.

Grading on a curve
Speaking of which, why exactly does Hidden Gems tells its subscribers to buy something other than the (apparently) best values available? Well, co-lead analyst Tom Gardner looks a bit deeper than the average Wall Street number-cruncher when choosing his picks. Tom employs a valuation method focusing not on a company's reported earnings under generally accepted accounting principles, but on the actual cash profits that the company generates, which he calls "owner earnings" (OE).

Personally, I use something between the simple P/E ratio and Tom's more complex price-to-OE ratio. I take the value of the business itself -- the enterprise value -- and compare that to the free cash flow the company generates, arriving at an enterprise value-to-free cash flow ratio (EV/FCF). Without boring you to death with the details, my valuations suggest that not one but four of the companies in this industry sell at prices that are both cheaper than the average S&P 500 stock, and cheap on an absolute basis as well. (Their EV/FCF ratios are lower than their growth rates.)

In order from cheapest to least cheap, these four stocks are: Career Education, Corinthian (NASDAQ:COCO), Apollo, and ITT (NYSE:ESI).

Corporate corporal punishment
Of course, there are reasons for three of the four being so cheap. As already discussed, Career Education must contend with ongoing investigations by the SEC, the Department of Education, and the Department of Justice. And both Apollo and Corinthian have been (allegedly) caught up in the stock-options backdating scandal. As far as I can tell, however, ITT is finally free of the former, and so far untouched by the latter.

Personally, I doubt that backdating stock options -- even if proven -- would pose a serious financial risk to the affected companies. And my impression from following Career Education's regulatory travails, through the prism of its SEC filings, is that "this, too, shall pass." But for those seeking an out-and-out bargain in the for-profit education sphere, and prefer one without the word "scandal" attached to any discussion of same, ITT gets my vote.

On that note: Stay in school, don't do drugs, and class dismissed. (But remember to come back tomorrow to read my piece on Extra Credit Investing.)

UTI is a Motley Fool Hidden Gems selection. To see what else Fool co-founder Tom Gardner is looking at, click here.

Fool contributor Rich Smith favors corporal punishment of stock-option backdaters -- a practice that would never pass the Fool's Honor Code. He owns no shares of any company named above.