Small- and mid-cap builders have closed the valuation gap between themselves and the big-caps, but for how long? By Alison Rice

Historically, smaller public builders such as Ryland, Meritage, Standard Pacific, M.D.C., and Beazer have traded at lower valuations than their big-cap colleagues. After all, they build fewer homes. They expect slower earnings growth. They have relatively less liquidity.

Yet this year these small- to mid-cap companies' stocks have been trading at essentially the same earnings and price-to-book valuations as their large-cap counterparts; Lennar, Centex, D.R. Horton, Pulte, and KB Home, all of whom boast market caps of $2 billion or more.

What gives? High hopes for big deals.

"In 2002, the small caps came into alignment with the big caps for the first time in a very long time," says Richard Thaler, managing director of Deutsche Bank Securities' industrials group in New York. With the ink barely dry on mega-mergers such as Lennar and U.S. Home, Pulte and Del Webb, and D.R. Horton and Schuler Homes, many expected that the deal-making had just begun. Smaller publics were the most likely targets--and their stock prices rose in anticipation.

As a result, the median 0.5 times price-to-book value premium enjoyed by the biggest builders, as calculated by Thaler, has nearly evaporated. The same goes for median P/E ratios, which compressed to 5.6 times earnings for the large caps and 5.1 for small to mid caps in early October. And, depending on what builders are chosen, those gaps close entirely. "There is no spread," says Paul Puryear, director of real estate research at Raymond James and Associates in St. Petersburg, Fla.

Ironically, this has dusted the chances for the potential public-to-public deals that inspired the higher valuations in the first place. When there's no disparity between trading multiples, builders can't purchase fellow publics without diluting their earnings per share. So they buy private builders instead.

But multiples may not stay equal for long. "We're starting to see these guys break out," says Thaler. Lennar, for example, is currently one of the most-watched public builders, thanks to strong margins, low debt, and a string of strategic acquisitions. Its stock closed at $59.83 on Oct. 21, trading at a P/E of 8.13 while other large- and smaller-cap builders hovered around multiples of seven.

Such gaps, if they widen for Lennar and other leading builders, represent a "huge competitive advantage," Thaler says. They also could signal a revival of the public/public deal-making envisioned--but not realized--in 2002.