Equity Investments — Study Notes

CFA® Level I topic weight 11–14% · markets, efficiency, and valuation

Markets, orders & indexes

Order types: market orders demand immediate execution (certain execution, uncertain price); limit orders set a price bound (certain price, uncertain execution). Stop orders become market orders when the stop price trades — they are used to limit losses, not guarantee them.
Margin buying: leverage magnifies both returns and losses. The leverage ratio = 1 ÷ initial margin (50% margin = 2× leverage), and a maintenance-margin breach triggers a margin call — a common calculation question.
Index weighting: a price-weighted index (buy one share of each) is biased toward high-priced stocks and distorted by splits; a market-cap-weighted index mirrors the market but concentrates in the largest names (float adjustment removes closely held shares); an equal-weighted index overweights small stocks and requires constant rebalancing.

Market efficiency & industry analysis

Three forms of efficiency: weak form — prices reflect all past price/volume data, so technical analysis adds nothing; semi-strong — prices reflect all public information, so fundamental analysis of public data adds nothing; strong form — prices reflect even private information, so nothing works. Most developed markets test as roughly semi-strong efficient.
Anomalies (size, value, momentum, calendar effects) challenge efficiency but often shrink after discovery or fail to survive costs — the exam wants the interpretation, not the catalog.
Industry analysis: Porter’s five forces — rivalry, threat of entry, threat of substitutes, supplier power, buyer power — determine industry profitability. Layer on the industry life cycle (embryonic, growth, shakeout, mature, decline) and external drivers (demographics, technology, regulation).

Dividend discount valuation

General principle: intrinsic value is the present value of expected future cash flows to the shareholder — dividends, or free cash flow to equity when dividends do not reflect capacity to pay.
Gordon growth model: V₀ = D₁ ÷ (r − g), where D₁ = D₀(1 + g) is next year’s dividend, r the required return, g the constant growth rate. Valid only when g < r and the firm is in stable growth — small changes in (r − g) move the value dramatically.
Multi-stage models handle fast growers: forecast dividends through the high-growth years, then apply Gordon growth as a terminal value once growth stabilizes.
Sustainable growth: g = b × ROE, where b is the retention ratio (1 − payout ratio). Growth comes from reinvested earnings times the return earned on them.
Preferred stock: a perpetuity — V = D ÷ r — because the dividend is fixed and has no growth.

Multiples & enterprise value

Trailing vs forward P/E: trailing uses the last 12 months’ EPS; forward uses expected EPS. Multiples fail when earnings are negative or temporarily distorted — then P/B, P/S or EV/EBITDA step in.
Justified (fundamental) P/E: from Gordon growth, P₀/E₁ = (1 − b) ÷ (r − g) — the payout ratio over (r − g). Higher payout raises the multiple only if ROE on retained earnings does not exceed r; higher required return lowers it.
Method of comparables: value a stock against peers’ multiples — the implicit assumption is that peers are correctly priced; a stock can look “cheap” against an overvalued sector.
Enterprise value = market cap + market value of debt + preferred − cash and equivalents. EV/EBITDA compares whole-firm value with a pre-interest earnings measure — useful across different capital structures and when net income is negative.
Asset-based valuation (adjusted net asset value) suits firms with mostly tangible, separable assets; it struggles with intangibles-heavy businesses.

Common traps

Plugging D₀ into the Gordon model — the numerator is next period’s dividend D₁ = D₀(1 + g).
Using Gordon growth when g ≥ r — the model breaks; a multi-stage model is required for high growth.
Claiming technical analysis works in a weak-form-efficient market — weak-form efficiency is precisely what rules it out; fundamental analysis of public data is ruled out by the semi-strong form.
Forgetting that price-weighted indexes are distorted by stock splits — the divisor adjusts, and the high-priced stock’s influence drops after a split.
Comparing P/E across firms with different leverage when EV/EBITDA is the cleaner cross-structure multiple.

For exam preparation reference only — original condensed summaries of publicly known Level I curriculum concepts. Independent study aid. CFA Institute does not endorse, promote, or warrant the accuracy or quality of this product. CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.