Is Ares Capital’s Huge Dividend Worth It?

Ares Capital (NASDAQ:ARCC) is a business development company (BDC) that owns stakes in businesses ranging from the software industry to the insurance world.

The stock currently offers a sky-high dividend of 8.9%, over six times the S&P 500 average. Though this dividend is extremely high, it may also come with outsized risks.

Is the Ares Capital dividend worth it, or is it best to look elsewhere for income-generating assets?

Why Is The Yield So High In a BDC?

BDCs carry somewhat unique risks that need to be well understood before deciding to buy shares in them.

These companies invest in small and mid-sized private businesses by making them loans that they might not receive through normal financing channels. The returns a BDC earns by successfully lending to these businesses are then passed onto its shareholders.

In a sense, BDCs can be thought of as something very close to publicly traded equivalents of private equity funds.

BDCs borrow money to invest in these businesses, making the model an inherently debt-heavy one. As such, they can be very sensitive to changes in the interest rate environment.

Due to the relatively small number of businesses available to invest in, BDCs also tend to be fairly concentrated. A noteworthy risk for investors exposed to investment model is the fact that the assets BDCs invest in are illiquid and may open the business development company up to financial risks in the event of defaults or economic downturns.

BDCs also carry higher tax burdens than traditional dividend stocks. Like real estate investment trusts, the dividends paid by BDCs are taxed as ordinary income. This can somewhat offset their high dividend yields, especially for investors in higher tax brackets.

Let’s Look at Ares Capital

Though BDCs carry some fairly high inherent risks, Ares Capital is in a better position than most.

To start with, Ares is by far the largest business development company by both market cap and net assets. The second-largest by market cap, Blue Owl Capital, is valued at less than half of Ares Capital’s total capitalization.

Ares also has a solid record of dividend growth that makes it more appealing. In 2009, the stock delivered $0.36 per share in dividends. Fast forward 15 years, and that number has increased more than five times to the current trailing 12-month payout of $1.92.

It’s also worth noting that share prices have risen from just over $3 to more than $21.50 over the same time frame, allowing investors to advantage of strong appreciation as well as attractive yields.

Given the fact that the company’s dividend payout ratio is still in a relatively safe range of about 65%, there’s also a good chance that payouts can continue growing over the next several years. This payout ratio percentage is moderate for a BDC and creates the conditions for a more stable and predictable dividend.

The company’s recent performance is another good reason for shareholders to be optimistic. GAAP net income per share rose to $0.76 in Q1, up from $0.52 a year earlier. This coincided with a more modest increase in fairly valued assets from $22.9 billion to $23.1 billion over the same period.

The company also maintains $509 million in cash and cash equivalents, down from $535 million at the end of last year.

On the downside, Ares Capital’s growth is expected to stall out over the coming few years. The 5-year earnings growth estimate suggests that earnings per share will contract by about 4% annually over the next half-decade.

This has the very real potential of arresting the stock’s upward march at a time when corporate earnings and share prices overall are expected to flourish.

Is Ares Capital Worth It?

Ares Capital has a strong track record of growing dividends and share price suggesting the high yield now is worth it.

With that said, Ares Capital’s price appreciation may have run into a bit of a plateau. Analyst predict an average target price of about $22 per share, just above where the stock is currently trading.

With a nearly 9% yield, though, Ares still offers income-oriented investors enough cash to make the stock look reasonably appealing.

For dividend growth investors, the answer is a bit more complicated. At the moment, the dividend payout ratio is high enough to allow for more growth. If earnings recede slightly as expected, though, the company is likely to be in for a period of lower dividend increases than it has historically managed.

This wouldn’t, however, be the first time that EPS numbers for Ares have plateaued. Trailing 12-month earnings peaked at nearly $4 in 2011 and didn’t regain similar heights again until 2021. The same 10-year period saw sustained and significant increases in dividend payouts from Ares Capital.

Careful financial management and a focus on long-term growth could keep the dividend rising even if earnings are trimmed in the coming few years.

Management Is Doing a Lot Of Things Well

Ares Capital has successfully managed to create a fairly diversified investment portfolio that offers its shareholders some degree of risk protection.

Per regulations on BDCs, no individual business can account for more than 25% of a business development company’s holdings.

Ares has holdings across more than 15 total industries and has achieved a decent level of geographic diversification.

While this doesn’t completely mitigate the risks that are associated with BDCs, Ares seems to have constructed a portfolio that manages those concerns well.

A final point to consider is the fact that Ares likely isn’t for conservative investors. The business and financial risks BDCs take on are much greater than traditional dividend investments like the S&P 500 dividend aristocrats.

This fact accounts for the much higher yields BDCs offer their shareholders. Even though Ares Capital has managed its risks well and has a good track record, it’s important to keep in mind that ARCC is far from a conservative stock to buy.

ARCC is more likely a stock that will appeal most to risk-tolerant investors looking for immediate income from their portfolios.

Though it also has long-term dividend growth potential, the earnings outlook for the next few years could result in lower payout increases and a slower rate of price appreciation.

The stock, however, could be a worthwhile addition to an income portfolio for those who are concerned with earning very high yields on their money today.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.