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CFA Level 1 Equity Investments: Complete Study Guide (2026)

All 8 Learning Modules at a Glance

LM 1: Market Organization and Structure

This module covers the full architecture of financial markets — how the financial system functions, what types of assets and contracts exist, who the intermediaries are, and how trading actually works.

Functions of the Financial System

The financial system serves three core purposes: it helps people save, borrow, raise equity capital, manage risk, exchange assets, and trade on information. It determines rates of return through the interaction of supply and demand for capital. And it promotes capital allocation efficiency — directing capital to its most productive uses. When markets are informationally efficient, prices reflect available information and capital flows to the highest-value projects.

Assets, Contracts, and Intermediaries

The curriculum classifies financial assets into securities (fixed income, equities, pooled investments), currencies, commodities, and real assets. It then covers the four main contract types: forward contracts, futures contracts, swap contracts, and option contracts — a preview of the Derivatives topic.

Financial intermediaries include brokers (match buyers and sellers), exchanges and alternative trading systems (provide trading venues), dealers (trade for their own account, provide liquidity), arbitrageurs (eliminate mispricings), securitizers (pool and repackage assets), depository institutions, and insurance companies. Know the role of each and how they contribute to market efficiency.

Positions, Orders, and Market Structure

Long vs. short positions: A long position profits when the price rises; a short position profits when it falls. Short selling involves borrowing and selling securities you don’t own, with the obligation to return them later. The curriculum covers margin requirements, maintenance margins, and margin calls for leveraged positions.

Order types: Market orders (execute immediately at the best available price), limit orders (execute only at a specified price or better), and stop orders (trigger a market or limit order when a specified price is reached). Know the difference between a stop-loss order (sell if price drops to X) and a stop-buy order (buy if price rises to X). The curriculum also covers validity instructions (good-till-cancelled, day orders, fill-or-kill) and clearing instructions.

Primary vs. secondary markets: Primary markets are where new securities are issued (IPOs, seasoned offerings, private placements). Secondary markets are where existing securities trade. The health of secondary markets directly affects primary markets — companies can raise capital at lower cost when investors know they can easily sell their positions later.

Execution mechanisms: Quote-driven markets (dealers post bid and ask prices), order-driven markets (orders interact directly based on priority rules), and hybrid markets (combine both). The curriculum covers call markets (orders batched and executed at a single clearing price) vs. continuous markets (orders execute whenever matching orders meet).

LM 2: Security Market Indexes

This module covers how market indexes are constructed, calculated, and used — essential knowledge because indexes are the benchmarks against which virtually all portfolio performance is measured.

Index Construction and Weighting

Price-weighted indexes (like the Dow Jones Industrial Average): Each stock’s weight is proportional to its share price. A $200 stock has twice the influence of a $100 stock, regardless of company size. Stock splits require divisor adjustments. The main drawback: price weighting has no economic rationale — a stock’s price alone doesn’t reflect its importance.

Market-cap-weighted indexes (like the S&P 500): Each stock’s weight is proportional to its total market capitalization (price × shares outstanding). This is the most common weighting scheme because it reflects each company’s actual economic importance. Float-adjusted versions use only freely tradable shares, excluding insider holdings and government stakes.

Equal-weighted indexes: Every stock gets the same weight, regardless of price or market cap. This gives more influence to smaller stocks and requires frequent rebalancing (as prices change, weights drift). Equal-weighted indexes tend to outperform cap-weighted indexes during periods when small-cap stocks outperform, and underperform when mega-caps lead.

Fundamental-weighted indexes: Weight based on economic metrics (revenue, earnings, book value, dividends). These challenge the efficient market hypothesis — if prices are efficient, cap-weighting is optimal; if prices deviate from fundamentals, fundamental weighting may outperform.

Rebalancing and Reconstitution

Rebalancing adjusts weights back to target (for equal-weighted or fundamental-weighted indexes). Reconstitution changes the index membership — adding companies that now qualify and removing those that don’t. Both create trading activity and potential market impact, especially around reconstitution dates when index funds must buy additions and sell deletions simultaneously.

Uses of Indexes

The curriculum identifies six uses: gauging market sentiment, proxying for systematic risk and market returns, serving as asset class representatives in asset allocation, benchmarking active manager performance, and creating model portfolios for investment products (index funds, ETFs). The exam will test whether you understand the appropriate index choice for each use.

LM 3: Market Efficiency

One of the most conceptually important modules in the CFA curriculum. Market efficiency theory determines whether active management can add value — and that question underlies virtually every investment decision.

The Efficient Market Hypothesis (EMH)

A market is efficient with respect to a set of information if prices fully, quickly, and rationally reflect that information. The key implication: in an efficient market, you can’t consistently earn abnormal returns using that information set — the expected net-of-cost return from trading on it is zero.

Market value vs. intrinsic value: In efficient markets, market price equals intrinsic value (or deviates briefly and randomly). If markets are inefficient, skilled analysts can identify mispriced securities where market value differs from intrinsic value.

Three Forms of Efficiency

Evidence generally supports weak-form and semi-strong-form efficiency for developed markets (with caveats), but rejects strong-form efficiency — insider trading does generate abnormal returns, which is why it’s illegal.

Market Anomalies

The curriculum covers anomalies that appear to violate the EMH: time-series anomalies (calendar effects like the January effect, momentum, mean reversion), cross-sectional anomalies (size effect, value effect — small-cap and value stocks have historically outperformed), and other anomalies (closed-end fund discounts, post-earnings-announcement drift, IPO underperformance). For each anomaly, the exam may ask whether it truly violates efficiency or can be explained by risk, transaction costs, or data-mining bias.

Behavioral Finance

The curriculum introduces behavioral explanations for apparent market inefficiencies: loss aversion (feeling losses more intensely than equivalent gains), herding (following the crowd), overconfidence (overestimating analytical precision), information cascades (inferring information from others’ actions rather than independent analysis), and other biases. These concepts recur in Portfolio Management (behavioral biases module) and in the forecasting biases covered in FRA LM 12.

LM 4: Overview of Equity Securities

This module catalogs the types of equity securities and their risk/return characteristics — the building blocks for valuation in LM 8.

Common shares: Residual claim, voting rights, limited liability. The curriculum covers different share classes (dual-class structures with different voting rights), callable common shares, and putable common shares.

Preference shares: Fixed dividend (usually), priority over common shares in liquidation, typically no voting rights. Variants include cumulative (unpaid dividends accumulate), participating (share in profits above the fixed dividend), and convertible (can be exchanged for common shares). From a risk perspective, preferred stock sits between debt and common equity.

Private vs. public equity: Private equity includes venture capital, leveraged buyouts, and PIPEs (private investment in public equity). The curriculum covers the tradeoffs — less liquidity and price transparency vs. less regulatory burden and longer-term focus. This connects to the Alternative Investments topic.

Non-domestic equity: Direct investing in foreign markets, depository receipts (ADRs and GDRs), and the risk considerations of investing internationally (currency risk, political risk, liquidity differences). Know the distinction between sponsored and unsponsored depository receipt programs.

Return and Risk Characteristics

Equity returns come from two sources: capital gains (price appreciation) and dividend income. Total return = capital gain yield + dividend yield. The curriculum covers ROE decomposition (connecting to FRA DuPont analysis), the cost of equity (connecting to Corporate Issuers WACC), and the relationship between book value, intrinsic value, and market value.

LM 5: Company Analysis: Past and Present

This module teaches you how to analyze a company’s current business — the analytical foundation for the forecasting (LM 7) and valuation (LM 8) that follow.

Determining the Business Model

The curriculum walks through a structured approach: What does the company sell? Who are its customers? How does it generate revenue? What are its key resources and activities? This connects directly to the business model framework in Corporate Issuers LM 7.

Revenue Analysis

Revenue analysis starts with identifying revenue drivers — the factors that determine how much the company sells. These include volume (number of units or customers), price per unit, product mix, and geographic mix. Pricing power — the ability to raise prices without losing customers — is a critical competitive advantage. The curriculum covers top-down revenue analysis (starting from macroeconomic or industry data and working down to the company) and bottom-up analysis (starting from company-specific data).

Operating Profitability and Working Capital

Operating cost analysis distinguishes fixed vs. variable costs (operating leverage), and natural vs. functional classifications (raw materials vs. COGS; salaries vs. SG&A). The curriculum covers gross margin, operating margin, and EBITDA margin as measures of operating profitability. Working capital analysis connects to the cash conversion cycle and cash flow analysis from FRA.

Capital Investments and Capital Structure

How does the company invest? Sources and uses of capital analysis examines capital expenditures, acquisitions, and the funding mix (retained earnings, debt, equity). The curriculum teaches evaluation of capital investments using metrics like return on invested capital (ROIC) relative to WACC — value is created when ROIC exceeds WACC.

LM 6: Industry and Competitive Analysis

Industry analysis provides the context for company analysis — you can’t forecast a company’s future without understanding the competitive dynamics of its industry.

Industry Classification

Third-party classification schemes include GICS (Global Industry Classification Standard, developed by MSCI and S&P), ICB (Industry Classification Benchmark, developed by FTSE Russell), and government-based systems (NAICS, SIC). The curriculum covers their structure (sector → industry group → industry → sub-industry) and their limitations: companies that span multiple industries may be poorly classified; disruptive companies may not fit existing categories; and classifications change slowly relative to business model innovation.

Industry Survey

The curriculum provides a framework for surveying an industry: size and historical growth, stage of the industry lifecycle (embryonic, growth, shakeout, mature, decline), profitability measures (industry-level ROE, margins), and market share trends. Characterizing where an industry sits in its lifecycle is critical for forecasting growth rates and capital requirements.

Porter’s Five Forces

The centerpiece of competitive analysis. The five forces that determine industry profitability:

External Influences and Competitive Positioning

Beyond the five forces, the curriculum covers external influences: macroeconomic factors (GDP growth, interest rates), technological change, demographic shifts, government policy (regulation, subsidies, trade policy), and social/environmental trends. Competitive positioning analysis examines how individual companies differentiate — through cost leadership, product differentiation, or focus (niche) strategies.

LM 7: Company Analysis: Forecasting

This module bridges the backward-looking analysis of LM 5 with the forward-looking valuation of LM 8. It teaches you how to build forecasts for revenue, expenses, working capital, capital investments, and capital structure.

Forecast Approaches

Two main approaches: top-down (start with macroeconomic forecasts, estimate industry growth, then the company’s share) and bottom-up (start with company-specific drivers like store count, same-store sales, average transaction size). Most analysts use a combination. The curriculum emphasizes focusing on objects that are regularly disclosed — revenue segments, cost categories, capital expenditure plans — because these can be tracked against management guidance and peer comparisons.

Revenue Forecasting

Revenue forecast objects include total revenue, revenue by segment (product, geography, customer type), and key revenue drivers (volume × price, subscriber count × ARPU, units × ASP). The curriculum covers growth-rate-based approaches (apply a growth rate to historical revenue) and driver-based approaches (model the underlying factors). For mature businesses with stable operations, historical trends are reasonable starting points. For high-growth or cyclical businesses, driver-based models are more reliable.

Expense and Working Capital Forecasting

COGS forecasting typically uses a margin assumption (gross margin as a percentage of revenue) or a driver-based approach (cost per unit × volume). SG&A forecasting uses either a percentage of revenue or a build-up approach (headcount × compensation, marketing budget, R&D as a percentage of sales). Working capital forecasts use the cash conversion cycle framework: DSO × forecasted revenue / 365 = forecasted receivables, and so on.

Scenario Analysis

The curriculum devotes significant space to scenario analysis — modeling different economic outcomes (base case, optimistic, pessimistic) and their impact on financial results. This is where probability concepts from Quant meet practical company analysis: expected value = Σ (probability × outcome) across scenarios.

LM 8: Equity Valuation — Concepts and Basic Tools

This is the capstone module and arguably the single most important section for the exam. It brings together everything you’ve learned in Quant (TVM), FRA (financial statements), and the preceding equity modules into a valuation framework.

Categories of Valuation Models

Three broad categories: present value models (discount future cash flows — dividends, FCFE, FCFF), multiplier models (apply price ratios — P/E, P/B, P/S, EV/EBITDA), and asset-based models (value = adjusted net asset value). Each has strengths and limitations, and good analysts use multiple approaches for cross-validation.

The Dividend Discount Model (DDM)

The most fundamental present value model: the value of a stock equals the present value of all expected future dividends, discounted at the required rate of return.

Where D₁ is the expected dividend next period, r is the required rate of return, and g is the constant growth rate of dividends (which must be less than r). This deceptively simple model is powerful: it directly links stock value to dividends, growth, and risk. If growth increases or risk decreases, value goes up.

Preferred stock valuation is a special case: with a fixed perpetual dividend and no growth, V₀ = D / r. This is the zero-growth DDM — essentially a perpetuity.

Multistage DDM: For companies with non-constant growth (e.g., high growth for 5 years then stable growth forever), you discount each stage separately. The terminal value (at the point where stable growth begins) uses the Gordon Growth Model, and earlier dividends are discounted individually. The curriculum walks through two-stage and three-stage models.

Free Cash Flow Models

FCFE valuation replaces dividends with free cash flow to equity — the cash flow available to shareholders after all expenses, reinvestment, and debt payments. This is more appropriate than DDM when dividends don’t reflect the company’s ability to pay (many profitable companies pay minimal dividends). The FCFE model is:

FCFE connects directly to the free cash flow measures covered in FRA LM 5.

Multiplier Models

Price-to-Earnings (P/E): The most widely used multiplier. Trailing P/E uses last 12 months’ EPS; forward P/E uses expected EPS. The curriculum shows the link between P/E and the DDM: justified P/E = payout ratio / (r − g). This means P/E is higher when growth is higher, risk is lower, or payout is higher — not just an arbitrary market number.

Price-to-Book (P/B): Compares market value to book value of equity. Useful for capital-intensive industries and financial firms. P/B > 1 means the market values the company above its accounting net worth (indicating intangible value or future growth). P/B < 1 may signal distress or undervaluation.

Price-to-Sales (P/S): Useful for companies with negative earnings (early-stage or cyclical companies). Revenue is harder to manipulate than earnings, making P/S a more stable metric. But it doesn’t account for cost structure differences.

Price-to-Cash-Flow (P/CF): Uses operating cash flow or free cash flow instead of earnings. Less susceptible to accounting manipulation than P/E.

Enterprise Value

Enterprise Value (EV) = Market cap + Total debt − Cash. EV represents the total value of the business to all capital providers. The key multiplier: EV/EBITDA — useful for comparing companies with different capital structures because EBITDA is a pre-interest, pre-tax measure. A lower EV/EBITDA relative to peers (all else equal) suggests relative undervaluation.

Asset-Based Valuation

Value = fair value of total assets − fair value of total liabilities. Most appropriate for holding companies, real estate companies, natural resource companies, and companies being liquidated. Less useful for going concerns where significant value comes from intangible assets, growth, and human capital that don’t appear on the balance sheet.

Study Strategy for Equity Investments

The study plan allocates 30 hours across Weeks 9–10. Here’s the priority order:

LM 8 (valuation) is the highest-priority module in the entire equity section — possibly on the entire exam. DDM (especially Gordon Growth), P/E justified ratios, and EV/EBITDA are tested repeatedly. Practice the calculations until they’re automatic.

LM 3 (market efficiency) is the second priority. It’s conceptual but heavily tested — knowing the three forms and their implications is essential. Anomalies and behavioral finance are frequent question sources.

LM 5–7 (company and industry analysis) form a logical sequence. LM 6 (Porter’s Five Forces, industry lifecycle) is the most testable of the three. LM 7 (forecasting) connects FRA skills to valuation inputs.

LM 1–2 and LM 4 are foundational. Market structure (order types, execution mechanisms) and indexes (weighting methods) are tested but at a lower frequency. Read for comprehension, do the problems, and move on.