SCHOOL STOCKS ARE

rallying. The average one in our database is up 38% year-to-date, vs. 8% for the S&P 500 index.

In theory, a school should operate like the most profitable of retailers. The good it sells, knowledge, is free. The sales staff (sorry, teachers) is inexpensive. The pricing power is considerable, with grants and low-interest loans easy to come by. All of this means that for schools, the returns on equity profits as a percentage of the resources used to generate them, a key driver of stock prices are meaty. The average school in our database carries a ROE of 26%, about eight percentage points better than the median S&P 500 company.

Of course, the schools whose shares are available for investment are mostly trade schools. They cater to workers looking for career boosts, not to recent high school grads seeking a self-awakening mix of liberal arts courses and keg parties. These schools are more in the business of selling job opportunities than knowledge. But surging profits and enrollment in recent quarters among several of the top trade schools suggest their customers are convinced of the benefits.

Publicly traded schools are expected to increase their earnings by an average of about 18% a year over the next five years, vs. a simple average (not weighted for company size) of 12% for the S&P 500 index. But the bright prospects for the group aren't lost on investors. The average school carries a price/earnings ratio, based on current-year forecasts, of about 30, vs. an average of 20 for S&P 500 members. In other words, schools offer 50% faster earnings growth than the broad market, but to get it, you generally have to pay a 50% higher price. But there are still individual bargains to be found in the group. In fact, there are two. Only, one of them recently accepted a takeover offer.

The board of directors of Laureate Education agreed in early June to a $62-a-share offer made by an investment group led by the company's chief executive. Another investment firm that owns a 10% stake in the company, Select Equity, has called the offer too low, based on the company's recent earnings momentum and on the run-up in share prices for schools in general. The firm has a point. Laureate, an international specialist with schools in fast-growing markets like Latin America, China and India, is expected by analysts to increase its earnings by 23% a year over the next five years. Yet the takeover price, about where the stock now trades, values the company at just 25 times forecast 2007 earnings. Together those numbers make for a discount of more than a third to both the market and the industry. The boss, it seems, is getting a bargain.

Another school stock seems underpriced at the moment, this one less than a year old. Minneapolis-based Capella Education issued shares just last November. They're already up 85% and look likely to head higher. The company's Capella University, founded in 1993, operates entirely online. It has 19,000 students and offers 17 degrees. It offers a handful of bachelor's degrees in fields like accounting, marketing, criminal justice and graphics, plus master's degrees (including MBAs) and Ph.D. programs. The average student is 40 years old. More than three-quarters receive financial aid.

On May 5 the company announced that first-quarter sales had increased 26% to $52.8 million. Earnings doubled to $3.8 million. Per-share earnings of 23 cents topped estimates by four cents. Enrollment jumped 21%.

The company has suffered some negative headlines of late. It's one of many schools whose financial aid departments have been accused of accepting fees from lenders whose services they recommend to students. In Capella's case, New York's attorney general has accused its financial aid director (now on leave) of collecting $13,000 in fees from one of 15 lenders the school recommended. Also, several executives at the company cashed in part of their post-stock-offering wealth in May, but the bosses still have a considerable stake in shares.

Capella might look expensive at 41 times forecast 2007 earnings. But profits for the company are expected to increase 27% a year over the next five years. That suggests the shares are still 10% cheaper than those of the average school. And that's based on earnings projections. Capella has beaten those by double-digit percentages in each of its two quarters since going public.