Should You Buy Ares Capital Stock While It's Below $26?

Ares Capital's (NASDAQ: ARCC) stock has increased only about 40% during the past 10 years. If we include its reinvested dividends, it's delivered a stunning total return of nearly 260%.

Ares' stock is now trading near its all-time high, but it remains about $3 shy of Wall Street's top price target of $26. So should investors load up on this high-yield dividend stock before it exceeds that rosy estimate?

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What does Ares Capital do?

Ares Capital is a business development company (BDC) that provides capital to middle-market companies with $10 million to $250 million in annual earnings before interest, taxes, depreciation, and amortization (EBITDA). It aims to invest $30 million to $500 million in debt and equity in those companies.

Traditional banks are often reluctant to approve loans for these businesses, which are considered riskier clients than larger companies. BDCs fill that niche by providing those companies with higher-interest loans than traditional banks.

BDCs mainly offer floating interest rate loans (which are pegged to the Federal Reserve's benchmark interest rate), so elevated rates tend to boost their profits. However, interest rates also need to stay low enough to spur economic growth -- otherwise its clients will struggle to expand and repay their loans.

To dilute its overall risk, Ares Capital spreads its investments across 535 companies. About 63% of its portfolio consists of first- and second-lien secured loans, which put it far ahead of other creditors in the event of a bankruptcy. By comparison, its smaller competitor Main Street Capital (NYSE: MAIN) has invested in 193 companies so far.

The health of a BDC can be assessed by its debt-to-equity ratio, which needs to remain stable or even fall as it ramps up its investments, and its net assets per share, which reflect the underlying market value of its portfolio. During the past few years, its debt-to-equity ratio (net of available cash) declined while its net assets per share increased.

Data source: Ares Capital. *Net of available cash.

That progress is encouraging, but Ares' stock is still trading at a premium (about 15%) to its net assets per share. If we look back at the end of 2022, it was only trading $0.7 above its net assets per share. That premium valuation could limit its near-term gains and prevent it from rising to $26.

By comparison, Main Street Capital ended its latest quarter with a lower debt-to-equity ratio of 0.89. It expected to end 2024 with $31.62 to $31.68 in net assets per share -- which would be much lower than its share price of about $60.

How safe is its dividend?

In 2024, Ares generated core earnings per share (EPS) of $2.33 and paid out $1.92 per share in dividends. It doesn't raise its dividend every year, and it's still on track to pay a forward dividend rate of $1.92 per share -- which gives it a forward yield of 8.3%.

Analysts expect its core EPS to dip 6% to $2.19 per share in 2025 as interest rates decline, but it should easily cover its dividend payments for the foreseeable future. And at $23, Ares still looks cheap at just over 10 times this year's core EPS.

Declining interest rates could reduce Ares' bottom-line growth, but they will also make its dividend more appealing as fixed-income investments lose their advantage. Ares stock could also become more attractive as it trades closer to its net assets per share.

Should you buy Ares stock while it's below $26?

At $26, Ares would look a bit pricey at 12 times forward earnings and trade at an even bigger premium to its net assets per share. I'm not sure it will hit that price target in the near future, but it looks like a compelling buy at its current prices. Its stock certainly won't blast off anytime soon, but it could be a safe place to park your cash while earning a hefty dividend of more than 8%.

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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.