Where Will Ares Capital Corporation Be in 3 Years?

During the past three years, Ares Capital's (NASDAQ: ARCC) stock has risen about 6%. That gain might seem tepid, but it delivered a much bigger total return of 42% after including its reinvested dividends. That's because Ares is a business development company (BDC) that mainly focuses on paying high dividends to income-oriented investors. But will Ares keep generating big gains during the next three years? Let's review its business model, growth rates, and valuations to decide.

What happened to Ares Capital over the past few years?

As a BDC, Ares Capital makes loans to middle-market companies, which generate between $10 million and $250 million in annual earnings before interest, taxes, depreciation, and amortization (EBITDA). It usually invests between $30 million and $500 million in debt and equity in each company.

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BDCs have become more popular during the past two decades as traditional commercial lenders approved fewer loans to middle-market companies, which are considered riskier clients than larger companies. In exchange for taking on more risk, BDCs charge higher interest on their loans than standard banks.

To reduce that risk, Ares spreads its investments across 535 companies in more than 40 different industries. More than 60% of its loans are first- and second-lien secured loans, which puts it ahead of other creditors in case a company goes bankrupt. It also ended its latest quarter with a manageable debt-to-equity ratio of 1.03. By comparison, its smaller competitor Main Street Capital (NYSE: MAIN) invested in 193 companies and ended its latest quarter with a slightly lower debt-to-equity ratio of 0.89.

A BDC's financial health is usually determined by its debt-to-equity ratio and net assets per share. During the past four years, Ares Capital has kept its leverage under control while steadily increasing its net assets per share.

Data source: Ares Capital. *Net of available cash. 9M = nine months.

On the last trading day of 2022, Ares' stock closed at $18.47, just $0.07 above its net assets per share. At $22, Ares now trades at a premium to that metric. But Ares still doesn't look as expensive as Main Street Capital, whose current price of $58 is significantly higher than its $30.57 in net assets per share.

BDCs are now commanding higher valuations because they profit when interest rates rise, as they have during the past couple of years. BDCs mainly offer floating interest rate loans pinned to the federal funds rate, so high rates tend to boost their net profits.

However, BDCs also don't want interest rates that are too high because that would reduce the appeal of their loans (which are already offered at higher rates than banks) and increase the risk of borrower defaults. High rates also reduce the appeal of their dividends by boosting the yields of risk-free certificates of deposit and Treasury bills. So, just like banks, BDCs thrive in a Goldilocks market with elevated but sustainable interest rates.

What will happen to Ares Capital during the next three years?

The Federal Reserve cut its benchmark rates three times in 2024 but only anticipates two more rate cuts in 2025. That slowdown suggests inflation hasn't been tamed yet -- and investors should expect elevated interest rates for at least another year. Ares, Main Street, and other BDCs could be appealing investments in this kind of market.

Ares' forward dividend yield of 9% also looks much more attractive than the 10-year Treasury's current yield of 4%. However, investors should remember that Ares cut its dividends during both the Great Recession and the COVID-19 crash. So, while Ares pays a great dividend now, we shouldn't be surprised if it eventually has to rein in those payments.

As a BDC, Ares is obligated to pay out at least 90% of its pretax income as dividends to maintain a favorable tax rate. But if its income declines, its dividends will also drop.

From 2020 to 2023, Ares' net asset per share increased at a compound annual growth rate (CAGR) of 4.3%, even as the pandemic, inflation, rising rates, and geopolitical conflicts rattled the markets. Assuming those headwinds wane and Ares increases its net assets per share at a slightly faster CAGR of 5% from 2023 to 2027 while trading at a reasonable 10% premium to that metric, its stock could rise nearly 20% to $26 during the next three years.

That would be a decent gain, but investors will probably be more focused on its dividends, which should continue climbing as long as the macro environment holds steady. But if the market swoons again, investors should brace for a hit as its business buckles under the pressure of unstable rates and defaulted loans.

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Leo Sun has positions in Main Street Capital. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.