Equity markets, security indexes, market efficiency, industry analysis, dividend discount models, and price multiples for CFA Level I.
Definition first
This guide is designed for first-pass understanding. Start with core terms, then apply the framework in your own account workflow.
Equity Investments is where the CFA curriculum gets practical. After learning how to read financial statements and evaluate corporate decisions, this topic teaches you how equity markets actually work, how to value stocks, and whether you can beat the market at all. Carrying roughly 10–12% of the Level I exam weight, Equity Investments bridges the gap between accounting knowledge and real-world investment decision-making. This guide covers market mechanics, the efficient market hypothesis, industry analysis, and every valuation model the CFA Institute expects you to know.
Equity Securities: Types & Characteristics
Before diving into valuation, you need to understand what you're valuing. Equity securities represent ownership claims on a company's assets and earnings. The most common types are:
Common stock: The standard equity security. Common shareholders have voting rights (typically one vote per share), a residual claim on assets (they get paid last in liquidation, after creditors and preferred shareholders), and the right to receive dividends if declared by the board. Common stock has unlimited upside potential but can lose 100% of its value.
Preferred stock: A hybrid security with characteristics of both debt and equity. Preferred shareholders receive fixed dividends (like bond coupons) and have priority over common shareholders in dividend payments and liquidation. However, preferred shareholders typically don't have voting rights and have limited upside. Preferred stock can be cumulative (missed dividends accumulate and must be paid before common dividends), non-cumulative, participating (shares in extra dividends beyond the stated rate), convertible (can be converted to common stock), or callable (the issuer can buy it back at a specified price).
Depository receipts: ADRs (American Depository Receipts) and GDRs (Global Depository Receipts) allow investors to hold shares in foreign companies without dealing with foreign exchanges, currencies, or settlement procedures. A bank buys shares of the foreign company and issues receipts that trade on a domestic exchange.
The risk-return profile differs significantly across equity types. Common stockholders bear the most risk but capture all the upside. Preferred stockholders have more predictable income but limited appreciation potential, behaving more like fixed income instruments. Understanding these distinctions is essential for both the exam and real-world portfolio construction.
Market Organization & Structure
Equity markets are the infrastructure that enables buying and selling of securities. The CFA exam tests your understanding of how these markets are organized, the different types of orders, and the role of market participants.
Types of Markets
Exchanges: Centralized venues (NYSE, Nasdaq, London Stock Exchange) where buyers and sellers are matched according to transparent rules. Exchanges provide price discovery, liquidity, and regulatory oversight. Listed companies must meet listing requirements for size, financial condition, and governance.
Over-the-counter (OTC) markets: Decentralized networks of dealers who trade directly with each other. OTC markets handle securities not listed on exchanges, including many bonds, derivatives, and smaller company stocks. OTC markets are less transparent and typically less liquid than exchanges.
Dark pools: Private trading venues that don't display orders publicly before execution. Institutional investors use dark pools to execute large orders without moving the market price. If a pension fund wants to sell 5 million shares, displaying that order on a public exchange would cause the price to drop before the order is filled. Dark pools solve this problem but reduce overall market transparency.
Order Types
The CFA exam expects you to know the basic order types:
Market order: Buy or sell immediately at the best available price. Execution is guaranteed, but price is not. Use when speed matters more than price.
Limit order: Buy at or below a specified price, or sell at or above a specified price. Price is guaranteed if the order executes, but execution is not. Use when price matters more than speed.
Stop-loss order: Becomes a market order when the price reaches a specified trigger. Sell stop-losses are placed below the current price to limit downside. They don't guarantee a specific execution price — in a fast market, slippage can be significant.
Market Participants
Key participants include market makers (dealers who provide liquidity by quoting bid and ask prices), brokers (agents who execute orders on behalf of clients), institutional investors (mutual funds, pension funds, insurance companies, hedge funds), and retail investors (individuals). The bid-ask spread — the difference between the price at which a dealer will buy and sell — is the dealer's compensation for providing liquidity and bearing inventory risk.
Security Market Indexes
A security market index measures the performance of a defined group of securities. Indexes serve as benchmarks for portfolio performance, tools for asset allocation, and the basis for index funds and ETFs. The CFA exam tests three weighting methods:
Price-weighted: Each security's weight is proportional to its price per share. The Dow Jones Industrial Average (DJIA) is the most famous price-weighted index. A $200 stock has twice the influence of a $100 stock, regardless of the company's total market value. This means stock splits affect the index composition, requiring divisor adjustments. Price weighting is simple but economically arbitrary — a company's share price says nothing about its size or importance.
Market-capitalization-weighted (value-weighted): Each security's weight is proportional to its market capitalization (price x shares outstanding). The S&P 500 and most major global indexes use this method. Cap weighting reflects economic reality — larger companies have more influence. However, it naturally overweights overvalued stocks and underweights undervalued ones (since overvalued stocks have inflated market caps).
Equal-weighted: Each security has the same weight, regardless of price or market cap. Equal-weighted indexes must be rebalanced periodically (typically quarterly) because price changes cause weights to drift. Equal weighting gives more influence to smaller companies compared to cap weighting and has historically outperformed cap-weighted indexes (the small-cap premium), though with higher transaction costs due to frequent rebalancing.
The Efficient Market Hypothesis (EMH)
The Efficient Market Hypothesis, developed by Eugene Fama, is one of the most important and debated concepts in finance. It states that security prices fully reflect all available information, making it impossible to consistently earn abnormal returns (returns above what's justified by risk). The EMH has three forms:
Weak-Form Efficiency
Prices reflect all past market data (historical prices, volume, trading patterns). Implication: technical analysis (chart patterns, moving averages, momentum indicators) cannot consistently generate abnormal returns. If past price patterns predicted future prices, traders would exploit them until the patterns disappeared. Empirical evidence generally supports weak-form efficiency, though some anomalies persist (momentum effects, mean reversion).
Semi-Strong-Form Efficiency
Prices reflect all publicly available information, including financial statements, news, analyst reports, economic data, and management forecasts. Implication: neither technical analysis nor fundamental analysis (analyzing financial statements, valuation models) can consistently generate abnormal returns. When a company reports earnings, the price adjusts almost immediately — by the time you read the report and place a trade, the information is already priced in.
Event studies (examining stock price reactions to earnings announcements, stock splits, M&A deals) provide mixed evidence. Prices generally adjust quickly, but some anomalies suggest semi-strong efficiency isn't perfect: post-earnings announcement drift (prices continue moving in the direction of the earnings surprise), the value premium (low P/E stocks outperform), and the small-cap premium.
Strong-Form Efficiency
Prices reflect all information, including private (insider) information. Implication: even insiders cannot earn abnormal returns. This is the most extreme form, and empirical evidence consistently rejects it — corporate insiders do earn abnormal returns on their trades, which is why insider trading laws exist.
For CFA candidates, the practical takeaway is that markets are generally efficient but not perfectly so. Active management can potentially add value, but it's difficult, expensive, and most active managers underperform their benchmarks after fees. This is why passive investing (index funds) has grown dramatically — a theme explored further in portfolio management.
Industry & Company Analysis
Before valuing a specific stock, analysts typically conduct top-down analysis: economy first, then industry, then company. Industry analysis helps you understand the competitive dynamics that determine profitability.
The CFA curriculum references Porter's Five Forces framework:
Threat of new entrants: How easy is it for new competitors to enter the industry? High barriers (capital requirements, regulatory approvals, brand loyalty, economies of scale) protect existing players' profitability.
Bargaining power of suppliers: Can suppliers raise prices without losing customers? Concentrated suppliers with differentiated products have more power.
Bargaining power of buyers: Can customers negotiate lower prices? Large, concentrated buyers with many alternative suppliers have more power.
Threat of substitutes: Are there alternative products that meet the same need? The existence of substitutes limits pricing power.
Intensity of rivalry: How aggressively do existing competitors compete? Industries with many similar-sized competitors, slow growth, high fixed costs, and low switching costs tend to have intense price competition and lower profitability.
Industries also move through a life cycle: embryonic (slow growth, high investment), growth (rapid adoption, improving profitability), shakeout (slowing growth, consolidation), mature (stable growth, high profitability for survivors), and decline (shrinking demand). The stage of the life cycle affects appropriate valuation methods and expected returns.
Equity Valuation Concepts
Equity valuation is the process of estimating a stock's intrinsic value — what it's really worth based on its fundamentals. If the intrinsic value exceeds the market price, the stock is undervalued (buy). If the market price exceeds intrinsic value, it's overvalued (sell or avoid). The CFA exam covers two broad categories of valuation models: absolute (discounted cash flow) and relative (price multiples).
Dividend Discount Model (DDM)
The DDM values a stock as the present value of all expected future dividends. The general form is:
V0 = ∑ [Dt / (1 + r)^t]
Where Dt = expected dividend in period t and r = required rate of return. This model requires forecasting dividends into perpetuity, which is impractical. The Gordon Growth Model simplifies this by assuming dividends grow at a constant rate forever:
V0 = D1 / (r − g)
Where D1 = next year's expected dividend, r = required return, and g = constant dividend growth rate. For this model to work, g must be less than r (otherwise the value is infinite or negative). The growth rate should reflect sustainable long-term growth, typically no higher than nominal GDP growth for a mature company.
The sustainable growth rate — derived using the quantitative tools from earlier in the curriculum — can be estimated as: g = ROE x Retention Rate, where Retention Rate = 1 − Dividend Payout Ratio. A company that earns 15% on equity and retains 60% of earnings has a sustainable growth rate of 9%.
The Gordon Growth Model works best for mature, stable, dividend-paying companies (utilities, large banks, REITs). It's inappropriate for high-growth companies, companies that don't pay dividends, or companies with volatile earnings. For these, multi-stage DDMs (which assume different growth rates for different periods) or free cash flow models are more appropriate.
Multi-Stage DDMs
The two-stage DDM assumes a high-growth phase followed by a stable-growth phase. You forecast dividends individually during the high-growth phase and then apply the Gordon Growth Model for the terminal value:
V0 = ∑ [Dt / (1 + r)^t] + [Vn / (1 + r)^n]
Where Vn = Dn+1 / (r − g) is the terminal value at the end of the high-growth phase. The three-stage DDM adds an intermediate transition phase where growth declines linearly from the high rate to the stable rate.
Price Multiples: Relative Valuation
Price multiples compare a stock's market price to a measure of fundamental value. They're widely used because they're simple, intuitive, and easy to compare across companies. The CFA exam tests several multiples in depth:
Multiple
Formula
Best Used For
Limitations
P/E (Price-to-Earnings)
Market Price / EPS
Profitable companies with stable earnings
Meaningless for loss-making companies; earnings can be manipulated
P/B (Price-to-Book)
Market Price / Book Value per Share
Asset-heavy companies (banks, REITs, insurers)
Book value may not reflect fair value; less useful for asset-light firms
P/S (Price-to-Sales)
Market Price / Revenue per Share
High-growth or unprofitable companies
Ignores profitability; a company can grow revenue while destroying value
P/CF (Price-to-Cash Flow)
Market Price / Cash Flow per Share
Companies with large non-cash charges
Depends on which cash flow measure is used (CFO, FCF, EBITDA)
EV/EBITDA
Enterprise Value / EBITDA
Cross-company comparison regardless of capital structure
EBITDA ignores capex; not a true cash flow measure
Trailing vs Forward Multiples
Trailing multiples use historical data (last 12 months of earnings). Forward multiples use analyst estimates of next year's earnings. Forward multiples are generally preferred because they reflect expectations about the future, which is what drives stock prices. However, they rely on the accuracy of analyst forecasts, which are often wrong.
Justified Multiples
A justified multiple is derived from a fundamentals-based valuation model. For example, the justified trailing P/E from the Gordon Growth Model is:
Justified P/E = (1 − b) x (1 + g) / (r − g)
Where b = retention rate, g = growth rate, and r = required return. This shows that P/E multiples are driven by three factors: payout ratio (higher payout = higher P/E), growth (higher growth = higher P/E), and required return (higher risk = lower P/E). Comparing a company's actual P/E to its justified P/E helps determine whether the stock is over or undervalued.
Enterprise Value vs Equity Value
Enterprise Value (EV) = Market Cap + Debt − Cash. EV represents the total value of the business to all capital providers. EV-based multiples (EV/EBITDA, EV/Sales) are more appropriate when comparing companies with different capital structures because they remove the effect of leverage. A company funded entirely by equity and an identical company funded 50% by debt would have different P/E ratios but similar EV/EBITDA ratios.
Free Cash Flow Valuation: An Introduction
Free Cash Flow (FCF) models value a company based on cash flows available to investors after all operating expenses and capital expenditures are paid. There are two versions:
Free Cash Flow to the Firm (FCFF): Cash available to all capital providers (debt and equity). FCFF = EBIT x (1 − T) + Depreciation − Capex − Change in Working Capital. Discount at WACC to get enterprise value.
Free Cash Flow to Equity (FCFE): Cash available to equity holders after debt payments. FCFE = FCFF − Interest x (1 − T) + Net Borrowing. Alternatively, FCFE = Net Income + Depreciation − Capex − Change in Working Capital + Net Borrowing. Discount at the cost of equity to get equity value.
FCF models are more flexible than DDMs because they work for companies that don't pay dividends. They're the preferred approach for most professional equity analysts. However, they require more assumptions (revenue growth, margin trends, capex needs, working capital changes) and are sensitive to the terminal value assumption, which typically accounts for 60–80% of total present value.
Bringing It Together: A Valuation Workflow
Professional equity analysis follows a structured process:
Understand the business. What does the company do? What drives its revenue and costs? What is its competitive position? Industry analysis (Porter's Five Forces, life cycle) provides context.
Analyze the financials. Use financial statement analysis to assess profitability, efficiency, liquidity, and solvency. Identify trends and compare to peers.
Forecast future performance. Build revenue, margin, and cash flow projections based on your understanding of the business and industry.
Select the appropriate valuation model. DDM for stable dividend-payers. FCFF/FCFE for growth companies. Multiples for relative valuation and sanity checks.
Determine the discount rate. Use CAPM or build-up methods, as covered in corporate issuers.
Calculate intrinsic value and compare to market price. If intrinsic value significantly exceeds market price (with a margin of safety), the stock may be a buy.
Track Your Equity Portfolio with Clarity
The valuation concepts covered here aren't just for the CFA exam — they're the same frameworks used by professional money managers every day. Whether you're calculating a stock's intrinsic value using the Gordon Growth Model or comparing P/E ratios across an industry group, Clarity gives you a consolidated view of your equity portfolio. Track your holdings across brokerage accounts, monitor performance, and use what you've learned about market efficiency and valuation to make more informed decisions about where to allocate your next investment dollar.