Small Cap Valuations

The recent purchase of Reynolds and Reynolds (REY) by Universal Computer Systems explains some of the unusual valuations of smaller companies. Small companies have historically been valued at 20-25% less than their larger rivals. However, over the past few years this valuation has dramatically reversed so that now smaller companies trade at roughly 50% higher valuations. What's going on?

REY was just purchased by Universal Computer Systems. REY was founded in 1866 as a business forms company, refocused in 1927 to help car dealerships and has been recently a major computing systems supplier to the car dealership business. We have studied them for years. However, with no growth in earnings, REY's tremendous free cash flows have only justified a purchase valuation of $20 (10X cash flow) with roughly $40 as a sell price. That $40 is exactly what UCS paid. How do they pay top dollar?

Private equity. UCS is keeping the Reynolds and Reynolds name, trying to get some "synergistic" growth, removing a competitor all with private equity money. In a world of slow growth and low interest rates, these easily leveraged small companies are miracles of finance, justifying extraordinary multiples (63 here) in a low P/E market.