Equity Investments accounts for up to 12% of your CFA Level I score. Yet most candidates who fail this section don't miss questions because they forgot a formula; they miss them because they chose the wrong formula for the company described in the vignette. This guide teaches you the judgment to pick the right tool for the job.
Quick answer
The 2026 CFA Level I Equity Investments section (10-12% weight) tests your ability to select and apply the correct valuation model (DDM, FCF, Relative, Residual Income) based on a company's characteristics. Success requires understanding model assumptions and avoiding common traps like using the wrong discount rate.
Key facts
- Official Body
- CFA Institute
- Exam Weight (2026)
- 10–12% of the total Level I exam.
- Key Topics
- Market organization, industry and company analysis, and equity valuation.
- Recommended Study Hours
- 30-40 hours, as part of the 300+ total for Level I.
- Pass Rate
- The CFA Institute reports the May 2024 Level I pass rate was 37% (CFA Institute).
- Exam Format
- Multiple-choice questions presented in vignettes.
The #1 Mistake Candidates Make in Equity Valuation
The single biggest mistake is a failure of judgment, not memory. It's applying a model to a company whose characteristics violate the model's core assumptions.The exam will give you a vignette about a company. Your first job is to classify it. Is it a mature, dividend-paying utility company? Or a high-growth tech startup with negative earnings? Your answer dictates your valuation approach.
- Mature, stable dividend-payer? A Dividend Discount Model (DDM) like the Gordon Growth Model is a strong candidate.
- Non-dividend-paying or erratic dividend history? DDM is useless. You must use a Free Cash Flow (FCF) or Residual Income (RI) model.
- Negative FCF due to heavy investment but positive earnings? Residual Income is often the best choice.
- Need a quick sanity check or valuing a private company? Relative valuation using multiples from comparable public companies is your tool.
The examiner will provide the data to calculate a value using an inappropriate model. The resulting wrong answer will be waiting for you as a distractor. Don't fall for it. Think first, calculate second.
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Which Valuation Model Should You Use? A Decision Framework
Your ability to select the appropriate model is the primary skill tested. This table summarizes your main options for the Level I exam.| Model Type | Key Models | Best Used When... | Key Assumption / Limitation |
|---|---|---|---|
| Dividend Discount (DDM) | Gordon Growth, 2-Stage | The company is mature, stable, and pays dividends that grow at a reasonable rate. | Highly sensitive to growth (g) and cost of equity (r) estimates. Useless for non-dividend-paying firms. |
| Free Cash Flow (FCF) | FCFF, FCFE | The company doesn't pay dividends or has unpredictable dividend patterns. Useful for a control perspective. | Requires detailed forecasts of capital expenditures and working capital. Terminal value is a huge driver. |
| Relative Valuation | P/E, P/B, P/S, EV/EBITDA | A quick valuation is needed and a set of clearly comparable public companies exists. | Assumes the market is pricing the comparable companies correctly. Can easily propagate mispricing. |
| Residual Income (RI) | RI = Net Income − (Equity Capital × Cost of Equity) | The company has negative free cash flow in the short term but positive earnings. Book value is meaningful. | Relies heavily on accounting data (book value, net income), which can be subject to manipulation. |
What are the Essential Formulas for Equity Investments?
Once you've chosen the right model, you need to execute the calculation flawlessly. Here are the non-negotiable formulas.Dividend Discount Models (DDM)
Values a stock based on the present value of its future dividends.Formula: Gordon Growth Model (GGM)
V₀ = D₁ ÷ (r − g)
- V₀: Current stock value
- D₁: Next year's expected dividend (D₀ × (1 + g))
- r: Cost of equity
- g: Constant dividend growth rate
Free Cash Flow (FCF) Models
Values the firm or its equity by discounting expected free cash flows.Formula: Free Cash Flow to Firm (FCFF)
FCFF = NI + NCC + Int(1 − Tax Rate) − CapEx − ΔWC
- NI: Net Income
- NCC: Non-Cash Charges (like depreciation)
- Int: Interest Expense
- CapEx: Capital Expenditures
- ΔWC: Change in Working Capital
Formula: Free Cash Flow to Equity (FCFE)
FCFE = NI + NCC − CapEx − ΔWC + Net Borrowing
Rule: Discount FCFE using the cost of equity (r) to find the value of equity directly. You can also derive FCFE from FCFF: FCFE = FCFF − Int(1 − Tax Rate) + Net Borrowing.
Relative Valuation & Multiples
Values a company by comparing it to similar companies using standardized ratios.- Price-to-Earnings (P/E): Market Price per Share ÷ Earnings per Share
- Price-to-Book (P/B): Market Price per Share ÷ Book Value per Share
- Enterprise Value to EBITDA (EV/EBITDA): (Market Cap + Debt − Cash) ÷ EBITDA. This is superior for comparing companies with different debt levels.
Required Return (Cost of Equity)
A critical input for all absolute valuation models.Formula: Capital Asset Pricing Model (CAPM)
r = RFR + Beta × (ERₘ − RFR)
- r: Cost of Equity
- RFR: Risk-Free Rate
- ERₘ − RFR: Equity Risk Premium
Worked example: Gordon Growth Model
Geneva Corp. just paid an annual dividend (D₀) of $1.50. The dividend is expected to grow at a constant rate of 4% per year. The company's cost of equity is 10%. Calculate the estimated value of Geneva Corp.'s stock.
Step 1: Calculate the next expected dividend (D₁)
The formula requires the next dividend, not the one just paid. D₁ = D₀ × (1 + g) = $1.50 × (1 + 0.04) = $1.56Step 2: Check the model's validity
The cost of equity (r = 10%) is greater than the growth rate (g = 4%). The model is valid.Step 3: Apply the Gordon Growth Model formula
V₀ = D₁ ÷ (r − g) = $1.56 ÷ (0.10 − 0.04) = $1.56 ÷ 0.06 = $26.00The estimated value of the stock is $26.00.
Exam trap: The most common wrong answer is calculated using D₀ in the numerator: $1.50 ÷ (0.10 - 0.04) = $25.00. The examiner knows you will make this mistake under pressure, and $25.00 will absolutely be an answer choice. Always calculate D₁ first.
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What Qualitative Frameworks Are Tested?
Not all questions involve a calculator. You must also understand the key frameworks for analyzing a company's competitive environment and market context. 1. Industry and Company Analysis:- Porter's Five Forces: This framework assesses industry attractiveness by analyzing the (1) threat of new entrants, (2) bargaining power of buyers, (3) bargaining power of suppliers, (4) threat of substitutes, and (5) intensity of rivalry.
- SWOT Analysis: A simpler framework analyzing a company's internal Strengths and Weaknesses, and external Opportunities and Threats.
- PESTEL Analysis: A broad framework for analyzing macro-environmental factors: Political, Economic, Social, Technological, Environmental, and Legal.
- Weak Form: Prices reflect all past market data (prices, volume). Technical analysis is useless.
- Semi-Strong Form: Prices reflect all public information (past data, financial statements, news). Both technical and fundamental analysis are useless.
- Strong Form: Prices reflect all public and private information. Even inside information is useless for generating excess returns.
The exam will test your ability to identify which form of efficiency is being violated in a given scenario. If a manager consistently earns abnormal returns by trading on non-public information, the market is not strong-form efficient.
How to Use This Cheat Sheet in Your Study Routine
This sheet is a high-yield review tool, not a substitute for the core curriculum.- Weekly Review: Spend 20 minutes each week quizzing yourself on the model selection table and the core formulas. Don't just read them; actively recall them from memory.
- Pre-QBank Primer: Before starting a block of practice questions, quickly review the relevant section here. This primes your brain and helps you connect theory to application. For example, before a DDM quiz, review the GGM formula and the D₀ vs. D₁ trap.
- Post-Mortem Analysis: After you complete a set of questions, use this sheet to diagnose your errors. Did you pick the wrong model? Use the wrong discount rate? Fall for the D₀ trap? Pinpoint the exact failure. VoraPrep's 2,500+ question bank provides detailed explanations for every answer choice, helping you see precisely where your logic went wrong.
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