Read This Before You Buy Prospect Capital Corporation Stock

By Markets Fool.com

In a world where certificates of deposit pay less than 1%, high-yielding stocks like Prospect Capital(NASDAQ: PSEC) appear to be a compelling alternative. After all, its monthly dividend of $0.083 per share amounts to an annual yield of nearly 12%. But before you dive in head first, there are a few things you should know.

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1. What it does
Prospect Capital is a business development company, required by law to pay out virtually all of its income as dividends. Its income comes from making debt and equity investments in private businesses -- businesses that are generally too small to sell stock or bonds to public investors.

BDCs typically make loans that banks can't or won't touch. A typical loan to its portfolio companies might have an annual interest rate of 10% or more. The high yields are a function of the risk. BDCs tend to underwrite "cash flow loans" that are not backed by significant hard collateral like real estate.

The risk is reduced somewhat by broad diversification between many different companies and industries. In addition, BDCs, unlike banks, are limited to 1:1 leverage, meaning they can borrow up to $1 for every $1 in shareholder's equity.

It also invests in companies it controls. Some of its largest controlled investments include subprime lenders, apartment communities, and a payment processing company. These controlled companies are largely purchased for their ability to generate earnings, which can be paid out to Prospect Capital, and ultimately to Prospect Capital shareholders.

2. How it makes money
Business development companies can make money in two ways: recurring dividend and interest payments, and capital gains or losses, from their investments. Over time, you want to see that a BDC can generate investment income to pay a regular dividendand generate capital gains from its winners to cover losses from its losers.

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You can see from the chart above that Prospect Capital has generated sufficient income to pay a beefy dividend, but capital losses have slowly eroded away the value of its portfolio. Prospect Capital currently has a net asset value -- book value -- of $10.35 per share, substantially below its net asset value per share of $13.67 at the end of its first ever reporting quarter in 2004.

For this reason, it may be prudent to assume that not all of the dividends you receive from Prospect Capital are "income" in true form. If its underwriting record holds, the company's book value will slowly decline over time, and its ability to pay dividends should decline, too. Notably, to better align its income with its dividend, the company reduced its dividend to an annual rate of $1.00 per share, down from $1.32 per share, in Dec. 2014.

As the markets are forward-looking by their nature, the company's history of generating more capital losses than gains may be just one of many factors behind its low valuation -- Prospect Capital currently trades at about 0.82 times its net asset value. Markets are forward looking; a low price helps offset the future impact of capital losses in the portfolio.

3. BDCs create a special kind of conflict
In general, BDCs suffer from disconnects between a management team's incentive to grow the business and the shareholder's interest in generating a return. Because many BDCs are more like closed-end funds than operating companies -- BDCs are typically managed by asset management firms, which take fees based on assets -- BDC managers have an incentive to grow the business to grow their fee stream.

This problem isn't unique to Prospect Capital. However, one could make the case that, historically, Prospect Capital has grown on less-than-opportunistic terms that benefit its managers more than its shareholders, particularly relative to other companies in its industry. Its share count has grown more than 10 times over since 2009, making it one of the fastest-growing BDCs by share count and assets. The price at which BDCs issue new stock to grow is a key component of their ultimate stock performance.

For this reason, it would be prudent to expect that its shares will likely never trade at a substantial premium to book value, as it has a history of issuing new shares when its share price exceeds book value, capping its share price appreciation. Occasionally, it has also issued shares below book value. This factor plays an important role in how the market prices the stock, and, again, is just another factor behind its big discount to book value and above-average dividend yield.

The article Read This Before You Buy Prospect Capital Corporation Stock originally appeared on Fool.com.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Apple and Bank of America. The Motley Fool owns shares of Apple and Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.