I have establushed that the true value is 45.71 and that it should be longed, bu
ID: 2736185 • Letter: I
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.