During the past three years, Ares Capital‘s (Nasdaq:ARCC) The stock rose about 6%. This gain may seem tepid, but it generated a much larger total return of 42% after including its reinvested dividends. That’s because Ares is Business Development Company (BDC) Which mainly focuses on paying high dividends to income-oriented investors. But will Ares continue to make significant gains over the next three years? Let’s review its business model, growth rates, and valuations to make a decision.
As a BDC, Ares Capital provides loans to middle market companies, which generate between $10 million and $250 million annually Earnings before interest, taxes, depreciation and amortization (EBITDA). It typically invests between $30 million and $500 million in debt and equity in each company.
Image source: Getty Images.
Business development companies have become more popular over the past two decades, as traditional commercial lenders have approved fewer loans to middle-market companies, which are riskier clients than larger companies. In exchange for taking on more risk, business development companies charge higher interest on their loans than traditional banks.
To reduce this risk, Ares distributes its investments among 535 companies in more than 40 different industries. More than 60% of its loans are first- and second-tier secured loans, putting it ahead of other creditors in the event of a company bankruptcy. It also ended the fourth quarter with a manageable debt-to-equity ratio of 1.03. In comparison, its smaller competitor Main Street Capitato (NYSE: Main) He invested in 193 companies and ended his last 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. Over the past four years, Ares Capital has kept its leverage in check while steadily increasing its net assets per share.
metric
2021
2022
2023
9th month 2024
Debt to equity ratio*
1.21
1.26
1.02
1.03
Net assets per share
$18.96
$18.40
$19.24
$19.77
Data source: Ares Capital. *Net cash available. 9 AD = 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 is now trading at a premium on this metric. But Ares still doesn’t look as expensive as Main Street Capital, whose current price of $58 is well above its net assets of $30.57 per share.
Business development companies now command higher valuations because they profit when interest rates rise, as they have over the past two years. BDCs primarily offer loans with variable interest rates fixed to the federal funds rate, so higher rates tend to boost their bottom lines.
However, BDCs also do not want interest rates to be too high because that would reduce the attractiveness of their loans (which are already offered at higher interest rates than banks) and increase the risk of borrower default. Higher rates also reduce the attractiveness of their dividends by boosting the yields of risk-free certificates of deposit and Treasury bills. So, just like banks, BDCs thrive in a moderate market with high but sustainable interest rates.
The Fed has cut benchmark interest rates three times in 2024, but expects only two additional rate cuts in 2025. This slowdown suggests that inflation has not yet been tamed — and investors should expect higher interest rates for another year to come. least. Ares, Main Street and other BDCs can be attractive for investments in this type of market.
Ares’s futures dividend yield of 9% also looks more attractive than the current 10-year Treasury yield of 4%. However, investors should remember that Ares cut its dividend during the Great Recession and the COVID-19 collapse. So while Ares is paying a large dividend now, we shouldn’t be surprised if it eventually has to rein in those payouts.
As a BDC, Ares is obligated to pay at least 90% of its pre-tax income as dividends to maintain an appropriate tax rate. But if its income decreases, its profits will also decrease.
From 2020 to 2023, Ares’ net assets per share increased at a compound annual growth rate (CAGR) of 4.3%, even as the pandemic, inflation, rising prices and geopolitical conflicts rocked markets. Assuming these headwinds subside and Ares increases its net assets per share at a slightly faster 5% CAGR from 2023 to 2027 while trading at a reasonable 10% premium to this metric, its stock could rise roughly 20% to $26 over the three years. Coming. .
That would be a decent gain, but investors will likely focus more on its earnings, which should continue to rise as long as the macro environment remains steady. But if the market declines again, investors should brace for a hit as its business collapses under the pressure of unstable interest rates and non-performing loans.
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Liu Sun He has positions at Main Street Capital. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has Disclosure policy.
