I have establushed that the true value is 45.71 and that it should be longed, bu

Question

I have establushed that the true value is 45.71 and that it should be longed, but dont know the answers to the rest of the question below.

Tiptons's stock has a required return of 12%, and the stock sells for $40 per share. The firm just paid a dividend of $1.00, and the dividend is expected to grow by 30% per year for the next 4 years, so D4 = $1.00*(1.3)4 = $2.8561. After t = 4, the dividend is expected to grow at a constant rate of 5% per year forever. What is the stock’s current true value. Should you long-or-short this security? What return would you expect to obtain from your trade if the stock reverts to the correct price over a 2-year period? What type of a position is this (speculative, value capturing, growth capturing, arbitrage, broker-dealer exchange spread)?    

Explanation / Answer

Beginning price = 40

Price after 2 years = 45.71

Dividend 1 =1 x (1+0.30) = 1.30

Dividend 2 = 1.30 x (1+0.30) = 1.69

Return = (Ending price + dividend) /Beginning price -1

                = (45.71 + 1.30 +1.69)/ 40   -1

                = 48.70/ 40 -1

                = 21.75%

So return would be 21.75%.

This is a value capturing position as the stock is being traded at a lower price than its true value. So the investor is putting his money and wants the stock to reflect its true value in near future and earn a decent return.

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