Ares Capital(NASDAQ: ARCC) is often considered a reliable income investment. It's the world's largest business development company (BDC), with a $26.8 billion portfolio at the end of 2024, and it pays out most of its profits as dividends. It currently pays a hefty forward dividend yield of 9.1%, and it has paid continuous dividends since its IPO in 2004. BDCs also need to pay out at least 90% of their taxable profits as dividends to maintain a lower tax rate.

But over the past 12 months, Ares' stock has stayed nearly flat as the S&P 500 rose 5%. Should investors expect it to hold steady and keep generating big dividends over the next 12 months?

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Understanding Ares Capital's business model

As a BDC, Ares mainly provides loans to "middle market" companies, which generate $10 million to $250 million in earnings before interest, taxes, depreciation, and amortization (EBITDA) each year. It usually invests $30 million to $500 million in debt and equity in each company in its portfolio.

Traditional banks are often reluctant to provide loans to middle-market companies because they're considered higher-risk clients, yet these companies are also too small to attract funding from private investors or venture capital firms.

Ares fills that gap by providing higher-interest loans than traditional banks. That strategy sounds risky, but it spreads its investments across 550 companies. It also mainly offers first and second lien secured loans (63.8% of its portfolio), preferred equity securities (9.9%), and senior subordinated debt (5.1%) -- all of which provide it with some protection from bankruptcies.

Ares' closest competitor, Blue Owl Capital Corporation(NYSE: OBDC), had a portfolio of 227 companies with a fair value of $13.2 billion at the end of 2024. Blue Owl Capital has locked up 81% of its portfolio in senior secured investments.

Ares' floating rate loans are pinned to the Federal Reserve's benchmark rate, so rising interest rates usually boost its net income. But if interest rates are too high, they'll stifle economic growth, hurt its clients, and make its loans less attractive. Therefore, Ares needs interest rates to stay in a "Goldilocks" zone to gain new clients and maintain a healthy investment portfolio.

How fast is Ares Capital growing?

Investors often evaluate a BDC with three key performance metrics: its net asset value (NAV) per share, if it's trading at a discount or premium to its NAV, and its debt-to-equity ratio. From 2004 to 2024, Ares' year-end NAV per share rose from $14.43 to $19.89 as it grew organically and acquired a long list of its industry peers.

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At its current trading price of $20.40, Ares Capital only trades $0.51 above its NAV per share at the end of 2024. It's historically traded at a $1 to $2 premium to its NAV per share. It also looks cheap at less than 10 times its forward earnings. But analysts expect its earnings per share (EPS) to drop 7% in 2025 and dip another 2% in 2026 as the Federal Reserve continues to cut its benchmark rate. However, its projected EPS of $2.16 this year should still easily cover its forward annual dividend rate of $1.92 per share.

Ares' year-end debt-to-equity ratio rose from 0.38 to 0.99 from 2014 to 2024 as it issued more loans, but its total liabilities haven't eclipsed its shareholder equity yet. Ares, like many other BDCs, issues new shares to fund its acquisitions and new investments. It has already increased its outstanding share count by 118% over the past 10 years. That might sound alarming, but it typically issues its new shares at a premium to its NAV -- so those offerings are accretive to its EPS.

Where will Ares Capital's stock be in a year?

I believe Ares' stock will trade sideways over the next 12 months. Interest rate cuts could throttle its near-term earnings growth, but lower rates should also drive more income investors from fixed-income investments (like CDs and T-bills) toward higher dividend stocks like Ares. Ares' high yield and low valuation should further limit its downside potential -- even if its core middle market companies grapple with tariffs, sticky inflation, and other macro headwinds.

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

Where Will Ares Capital Corporation Be in 1 Year? was originally published by The Motley Fool

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