Should You Buy Ares Capital (ARCC) Stock Before February? | The Motley Fool

Ares Capital ( ARCC +0.40%), the world's largest business development company ( BDC ), pays a substantial forward dividend yield of 9.6%. Some investors might consider it a high-yield trap, but it has generated an impressive total return of 245% over the past decade, including reinvested dividends. It also beat the S&P 500's total return of 236%. Should investors buy Ares' stock before its next earnings report in February? Let's review its business model, growth rates, and valuations to find out. Image source: Getty Images. Understanding Ares Capital's business model BDCs offer financing to "middle market" companies, which frequently struggle to secure loans from traditional banks because they're classified as higher-risk clients. These companies are also generally too small to attract funding from institutional investors. In exchange for taking on more risk, BDCs charge higher interest rates than traditional banks. The largest BDCs, like Ares, mitigate that risk by investing in hundreds of companies. NASDAQ: ARCC Key Data Points Ares spreads its investments across 587 companies, which are backed by 252 private equity sponsors, across its $28.7 billion portfolio. To stay ahead of other creditors in potential bankruptcies, it allocates 61.6% of its portfolio to first-lien secured loans, 5.8% to second-lien secured loans, and 5.2% to senior subordinated debt. It targets companies that generate $10 million to $250 million in earnings before interest, taxes, depreciation, and amortization ( EBITDA ) each year, and it invests $30 million to $500 million in debt and equity per company. Ares provides floating-rate loans that are pinned to the Fed's benchmark rates. To generate consistent profits, those rates need to stay in a "Goldilocks Zone". High interest rates boost its net interest income. Still, they also generate macroeconomic headwinds for Ares' portfolio companies, making its dividend-paying shares less attractive than risk-free CDs and T-bills. Lower interest rates make it easier for its portfolio companies to thrive while bringing back more income investors, but they also reduce its net interest income. Like real estate investment trusts ( REITs ), BDCs must pay out at least 90% of their pre-tax income as dividends to maintain a lower tax rate. BDCs are also valued by their net asset value ( NAV ) per share, rather than their earnings per share ( EPS ). If a BDC's stock price trades below its NAV, it's undervalued; if it's significantly higher, then it's overvalued. Is Ares Capital finally in the "Goldilocks Zone"? Ares Capital, like many other BDCs, generated higher profits in 2022 and 2023 as the Federal Reserve raised its benchmark rates eleven times from nearly zero to 5.25%-5.50%. From 2022 to 2023, its EPS more than doubled from $1.19 to $2.68 as its net interest income soared. In 2024 and 2025, the Fed cut its benchmark rate six times, from 3.50% to 3.75%, as inflation cooled. As a result, Ares' EPS declined 21% to $2.44 in 2024. For 2025, analysts expect another 21% drop to $1.94 per share. That will cover its forward dividend rate of $1.92 per...

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