Predicting Ares Capital Corporation's Position in the Next 3 Years
Over the past three years, Ares Capital Corporation's (ARCC 0.36%) stock has seen a 6% increase. However, considering the reinvested dividends, this figure jumps up to a whopping 42%. Ares Capital, being a Business Development Company (BDC), primarily focuses on dishing out high dividends to income-oriented investors. The question is, will Ares maintain its impressive returns in the coming three years? Let's delve into its business model, growth rates, and valuations to arrive at an answer.
What's the deal with Ares Capital's recent history?
As a BDC, Ares Capital loans to mid-sized companies, generating between $10 million and $250 million in annual Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). Typically, they invest between $30 million and $500 million in both debt and equity of each company.
The surge in popularity of BDCs over the past two decades is due to conventional lenders less likely to approve loans to mid-sized firms, considered riskier than their larger counterparts. To mitigate this risk, BDCs charge higher interest rates on their loans than standard banks.
Ares diversifies its investments across 535 companies in over 40 different industries. Sixty percent of its loans are secured, first- or second-lien, ensuring priority in case of company bankruptcies. The latest quarter closed with a modest debt-to-equity ratio of 1.03, contrasting with its competitor Main Street Capital's (MAIN 0.45%) ratio of 0.89.
BDCs' financial strength is often determined through their debt-to-equity ratio and net assets per share. Ares has successfully kept its debt under control while enhancing its net assets per share over the past four years.
| Metric | 2021 | 2022 | 2023 | 9M 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 |
Debt-to-equity ratio*
On the last day of 2022, Ares' stock closed at $18.47, just $0.07 above its net assets per share. At $22, Ares is trading with a premium, yet it appears more reasonably valued than Main Street Capital with a $58 price tag, significantly higher than its $30.57 net assets per share.
1.21
BDCs have seen higher valuations due to the rise in interest rates over the past few years. Their floating interest rate loans, tied to the federal funds rate, benefit from high rates, resulting in enhanced net profits.
1.26
However, high-interest rates can potentially decrease the appeal of BDC loans, already offered at premium rates, and increase borrower defaults. Additionally, high-interest rates reduce the appeal of their dividends by boosting the yields of Treasury bills and certificates of deposit. As a result, BDCs thrive in a market with sustainable, yet elevated interest rates, similar to banks.
1.02
What could happen to Ares Capital in the future?
1.03
The Federal Reserve reduced its benchmark rates three times in 2024 but anticipates only two more cuts in 2025. This suggests that inflation has yet to be contained—implying sustained elevated interest rates for another year. In this environment, Ares, Main Street Capital, and other BDCs could prove appealing investments.
$19.77
Ares' projected forward dividend yield of 9% outshines the current 10-year Treasury yield of 4%. However, investors must keep in mind that Ares cut its dividends during both the Great Recession and the COVID-19 crisis. While Ares currently offers an attractive dividend, a possible reduction in the future shouldn't be ruled out.
Net assets per share
As a BDC, Ares is obligated to distribute at least 90% of its pretax income as dividends to secure a favorable tax rate. Nevertheless, if its income decreases, so will its dividends.
$18.96
From 2020 to 2023, Ares' net asset per share increased by a steady 4.3% CAGR, despite market turbulences and external challenges. Assuming these hindrances ease and Ares manages to enhance its net assets per share at a 5% CAGR from 2023 to 2027 while trading at a reasonable 10% premium to that metric, its stock could potentially rise by around 20% to $26 over the next three years.
$18.40
While this would represent a solid gain, investors are likely to focus more on the dividends, which will likely continue to climb as long as market conditions remain stable. However, if the market experiences another downturn, investors should prepare for a hit as Ares' operations face pressure from fluctuating rates and defaulted loans.
$19.24
Given Ares Capital's focus on investing in mid-sized companies and its reliance on dividends for income-oriented investors, exploring potential finance opportunities in this sector could be beneficial. With its debt-to-equity ratio of 1.03, Ares Capital has maintained financial strength while enhancing its net assets per share, making it an appealing investment opportunity for those seeking dividend yields. As interest rates remain elevated, BDCs like Ares Capital and Main Street Capital could continue to thrive, potentially leading to further growth in their stock prices and dividends.
