Ares Capital(NASDAQ: ARCC), 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.
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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.
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.
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 share, but it clearly hasn’t reached its “Goldilocks zone” yet.
For 2026, most analysts anticipate at least two more rate cuts. Wall Street expects Ares’ EPS to barely rise to $1.95 in 2026 before dipping 1% to $1.92 in 2027. That outlook seems dim, but it indicates its current dividend yield is sustainable. Its firm financial discipline is reflected in its stable debt-to-equity ratio (net of available cash) of 1.02 at the end of the third quarter of 2025.
At $20 per share, Ares’ stock looks cheap at ten times next year’s earnings. It’s also hovering near its NAV of $20.01 per share at the end of September. In other words, its high yield and low valuation should limit its downside potential even as interest rates continue to decline.
Based on these facts, Ares should continue to be a resilient income generator for the foreseeable future. However, declining interest rates will also cap its near-term gains. Therefore, investors shouldn’t rush to buy Ares ahead of its next earnings report in February. They can certainty nibble on it to increase their passive income, but they should wait and see what Ares says about the near-term impact of the interest rate cuts on its profits before they buy a bigger position.
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Leo Sun has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Ares Capital. The Motley Fool has a disclosure policy.
