Low P/E Ratios Not a Good Enough Reason to Invest in For-Profit Colleges Sector

Few sectors have been surrounded by more controversy than for-profit colleges. I’m sure you’ve heard of the cheating scandals, high student-loan default rates, and "boiler room" tactics used by recruiters to entice students to enroll.

For-profit college stocks have plunged in the wake of government investigations and recently released regulations aimed at curbing student-loan abuses. Among the seven stocks in the for-profit education sector with market caps greater than $1 billion, prices have fallen an average of more than 40% from their all-time highs.

But these sharp price declines have many asking whether it’s time to jump back into these stocks based on depressed valuations. The average price-earnings ratio for these seven stocks is 12.1, compared to 14.3 for the S&P 500 index.

Sentiment surrounding these stocks has taken on a skeptical tint as well. Analysts have cooled toward these former growth stocks, with fewer than half now recommending them as a buy. That makes the for-profit education sector one of the least-loved among analysts.

Today, these stocks still have attractive P/E ratios amid a negative sentiment backdrop. For some value investors, this may be incorrectly interpreted as a time to buy.

The problem with these supposed value plays is that if you focus only on P/E, these stocks may appear cheap. But a true value investment is more than just a low P/E. You need predictable and consistent cash flow, a diversified revenue base, and -- perhaps most of all -- no controversy. It’s on those measures that the for-profits come up short.

Before I go on, I want to make it clear that I’m not here to bash higher education. Even for-profit schools have a place in providing postsecondary education. These institutions fill a valuable need for those looking to improve their professional skill sets.

Part of the rising demand for these schools came from those with degrees who wanted to learn new skills to enhance their chances for landing another job. Even those lucky enough to be employed knew that adding to their resumes gave them a better shot at just keeping their current job.

These days, having a college degree isn’t a guarantee of professional success. In fact, a recent New York Times article pointed out that "a college degree is no longer the guarantor of a middle-class existence."

But not having a college degree can mean giving up the chance of nailing down a decent-paying job. And with the job market tight (the unemployment rate may be headed lower, but no one is comfortable with 8.6%), a degree is almost a necessity. Maybe that’s partly why enrollment at for-profits soared 236% from 1998 to 2008, compared to less than 25% at public and private universities.

Unfortunately, though, this new demand has resulted in unscrupulous methods aimed at swelling the enrollment ranks to increase revenue. The problem is straightforward: These colleges derive most of their revenue (some estimate as high as 90%) from government-backed education loans that are relatively easy to obtain. And that creates an environment ripe for abuse.

Government investigations have found that unqualified students have frequently been lured into these schools with promises of federal loans and good-paying jobs after graduation. Some recruiters were even paid based on how many students they enrolled, a violation of federal law.

Many students were poorly prepared and found jobs that paid far less than they were led to believe -- that is, if they were lucky enough to find a job at all. Many also left these schools burdened by staggering debt loads that they were unable to repay.

The statistics are alarming. According to the US Department of Education, "students at for-profit institutions represent 12% of all higher-education students, 26% of all student loans, and 46% of all student-loan dollars in default."

Government scrutiny of the industry is intense, as Congress is wary of any loan program that ends up costing taxpayers in the end. It’s never a good thing when the Government Accountability Office puts out a report titled, "For-Profit Colleges: Undercover Testing Finds Colleges Encouraged Fraud and Engaged in Deceptive and Questionable Marketing Practices."