CFA Level I: Equity Investments

Equity Investments is one of the core areas of the CFA Level I curriculum, typically accounting for roughly 11 to 14 percent of the exam. That weight reflects its practical importance. For many candidates, this is where finance becomes tangible: real companies, real financial statements, and real market pricing. At Level I, the focus is not on building elaborate forecasts but on understanding how equity securities are analyzed, how industries shape company outcomes, and how valuation models translate fundamentals into a defensible estimate of value.

What “Equity Investments” Covers at Level I

At this level, equity analysis is about building a structured way to answer three questions:

1. What is the security, and what claims does it represent?
2. What is the company’s economic context, particularly its industry structure and competitive position?
3. What is the stock worth, based on reasonable valuation frameworks?

The curriculum emphasizes security analysis, industry analysis, and valuation models. You are expected to understand the mechanics and interpret results, not merely memorize definitions.

Security Analysis: Understanding What You Own

Security analysis starts with the equity instrument itself and the market where it trades.

Equity securities and shareholder claims

Common shareholders typically have residual claims on a firm’s cash flows and assets. That single idea explains a lot: equity is more volatile than debt, dividends are discretionary, and valuations are sensitive to growth expectations and profitability. Preferred shares, where covered, add nuance by introducing hybrid characteristics such as fixed dividends and priority over common equity in distributions.

Equity market organization and indexes

Level I expects familiarity with how equities trade, including the role of exchanges and the idea of market efficiency as it relates to information and pricing. Indexes come up frequently because they are the baseline for performance measurement and passive investing. Understanding price-weighted vs. market-cap-weighted indexes helps explain why some index returns can be dominated by a small number of large constituents, and why rebalancing rules matter.

Reading equity returns and risk in plain terms

Equity returns come from price appreciation and dividends. Even without advanced modeling, you should be comfortable decomposing returns and connecting them to business performance. Risk discussions often connect to the idea that equity holders bear business risk, financial leverage risk, and industry risk. The practical payoff is being able to interpret why two companies with similar earnings can trade at very different valuations.

Industry Analysis: Context Before Company-Specific Valuation

A common mistake in beginner equity valuation is treating firms as isolated. The curriculum pushes you to start with industry analysis because industry structure shapes pricing power, margins, and growth.

Industry classification and peer comparison

Industry classification systems exist to group companies by economic activity, but the real use in analysis is comparability. Peer groups help you interpret valuation multiples. A $20$ P/E ratio may be high for a mature utility but ordinary for a high-growth software firm. Without industry context, multiples are misleading.

Competitive dynamics and profitability

Industry analysis looks at how competition affects long-run returns. A highly competitive industry with low switching costs often struggles to sustain high margins. In contrast, industries with barriers to entry, strong brands, network effects, or regulatory constraints may support more stable profitability.

You do not need to recite strategy frameworks mechanically. What matters is recognizing cause and effect: structural advantages can support higher returns on equity, more predictable cash flows, and therefore higher valuation.

Cyclicality and sensitivity to the economy

Industries differ in how they respond to economic cycles. Consumer staples and utilities often show steadier demand, while autos, airlines, and luxury goods tend to be more cyclical. This matters because valuation depends on expectations of future cash flows, and cyclical cash flows deserve more caution in forecasting and a stronger focus on normalization.

Valuation Models: Translating Fundamentals Into Value

Valuation sits at the center of Equity Investments at Level I. The key is understanding models well enough to apply them and interpret their assumptions.

Present value logic and the role of expectations

At its core, equity valuation reflects discounted future benefits to shareholders. The discount rate captures the required return, while expected cash flows reflect profitability, growth, and reinvestment needs. Even when a model uses dividends or earnings as inputs, the underlying logic is the same: value rises with higher expected future distributions and falls with higher required returns.

Dividend Discount Model (DDM)

The Dividend Discount Model is a foundational approach because it directly values what shareholders receive: dividends. The simplest form, the Gordon growth model, assumes dividends grow at a constant rate $g$ and are discounted at required return $r$:

$$V_0=\frac{D_1}{r-g}$$

This model is powerful but sensitive. Small changes in $r$ or $g$ can swing value dramatically, especially when $r$ is close to $g$. Level I candidates should be able to interpret when the DDM is appropriate, typically for firms with stable dividend policies and predictable growth.

In practice, many firms do not pay meaningful dividends or have inconsistent payout patterns. That does not make the model useless, but it does push you toward other methods.

Multiples-based valuation (market multiples)

Price multiples are widely used because they are simple and anchored in market pricing. Common examples include P/E, P/B, and P/S. The curriculum emphasizes understanding what drives a multiple and what can distort it.

• P/E relates price to earnings but can be distorted by cyclical earnings, one-time items, and differences in accounting.
• P/B can be useful for financial firms or asset-heavy businesses, but book value may be less informative for companies with significant intangible assets.
• P/S avoids some earnings noise but ignores profitability differences unless combined with margin analysis.

Multiples are most meaningful in relative valuation, comparing a firm to peers with similar growth prospects, risk, and business models. A high multiple is not automatically “overvalued.” It may reflect higher expected growth, higher margins, or lower perceived risk.

Asset-based valuation: balance sheet as a starting point

Asset-based approaches value a firm based on the market value of assets minus liabilities. At Level I, the key takeaway is when this approach is informative: companies with significant tangible assets, investment holdings, or when liquidation value is relevant. For operating businesses where value is primarily tied to future earnings power, asset-based measures may understate value, particularly when intangible assets drive cash flows.

Connecting Industry Analysis to Valuation

The strongest equity answers integrate the pieces:

• Industry structure influences sustainable margins and growth.
• Sustainable margins and growth drive expected cash flows or earnings.
• Risk and cyclicality influence the required return and how conservative assumptions should be.
• The valuation model chosen should match the company’s characteristics and the reliability of inputs.

For example, a mature consumer staples company with stable dividends may fit a DDM-style approach, while a non-dividend-paying growth company may be more naturally assessed through peer multiples, supported by careful profitability and reinvestment analysis.

Practical Exam Focus: How Level I Tests Equity Investments

Equity Investments questions often test whether you can:

• Interpret valuation model inputs and outputs, not just compute them.
• Identify when a model is appropriate or inappropriate.
• Compare companies using multiples and explain differences logically.
• Use industry context to avoid faulty comparisons.
• Recognize how assumptions about growth and required return affect estimated value.

Success comes from being disciplined with definitions and comfortable with simple valuation mechanics. Many candidates lose points by treating formulas as isolated tools rather than expressions of economic relationships.

How to Study Equity Investments Efficiently

A practical approach is to study in the same order you would analyze a real company:

1. Learn the equity security basics and how equity returns are generated.
2. Build industry intuition: how firms compete, where profits come from, and what risks matter.
3. Master the major valuation models and, more importantly, their assumptions and limitations.
4. Practice comparing companies with multiples using consistent peer sets and sensible narratives.

Equity Investments at CFA Level I is less about being “right” on a single intrinsic value number and more about demonstrating sound reasoning. If you can connect business realities to valuation drivers and select tools that fit the situation, you are learning the subject the way the profession uses it.