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Study guide · Session 2

Equities

11-14% of the exam · session 2 · 12 learning modules

Equities covers what shares are and how they trade, how shareholders earn returns, and how analysts value a company with present value models, multiples and forecast models built on industry and company analysis. Level I questions mix definitions and structure with short valuation calculations: dividend discount models, preferred shares, multiples, enterprise value, float, total return and the CAPM.

A study feature written by ExamDragon, not part of the real exam. Each heading is one of this topic's 12 learning modules in the 2027 curriculum, named in our own words.

At a glance

Session 2
11-14%

of the exam, as CFA Institute weights it for 2027

Weight
11-14%
Modules
12
Key terms
10

What this guide covers, module by module

  1. EQ.1Shares: types and core features
  2. EQ.2Share classes, votes and proxy advice
  3. EQ.3Equity markets, trading venues and indexes
  4. EQ.4Dividends, buybacks, splits and share returns
  5. EQ.5Price, value and families of valuation models
  6. EQ.6Present value models for shares
  7. EQ.7Valuing shares with price and EV multiples
  8. EQ.8Building forecast models to value equity
  9. EQ.9Analysing industries and competitive forces
  10. EQ.10Company strategy, drivers and capital needs
  11. EQ.11Writing and reading equity research
  12. EQ.12CAPM and factor models for required return

EQ.1Shares: types and core features

  • Common shares carry the residual claim: they are paid last in liquidation but keep all value above other claims, and usually carry the votes.
  • Preferred shares rank ahead of common for dividends and in liquidation, usually pay a fixed dividend and usually have limited or no votes.
  • Cumulative preferred shares carry unpaid dividends forward as arrears that must be cleared before any common dividend; participating preferred shares can share in extra profits; convertible preferred shares can be exchanged for common shares.
  • Callable shares give the issuer the right to buy them back at a set price; putable shares give the holder the right to sell them back.
  • Depository receipts let investors hold a foreign company's shares through a security traded on their local market.
  • Private equity securities have no public market: they are less liquid, disclose less and are priced only at transactions, so investors demand a higher return.
  1. The situationA company is wound up. After creditors are paid, EUR 50 million remains; preferred shareholders have a liquidation claim of EUR 20 million.
  2. Step 1Preferred shares rank ahead of common, so preferred holders receive their EUR 20 million in full.
  3. Step 2Common shareholders receive the residual: 50 - 20 = EUR 30 million.
  4. Where questions turnCumulative, participating and convertible are different features: only cumulative creates dividend arrears.
  5. The takeawayPreferred holders have priority but a capped claim; common holders bear the loss first and keep any surplus.
Practise EQ.1

EQ.2Share classes, votes and proxy advice

  • Jurisdictions differ in shareholder rights: how directors are elected, which decisions need a shareholder vote, and how easily minorities can challenge the board.
  • Share classes can split economic rights from voting rights; dual-class structures give insiders more votes per share than public holders.
  • Separating votes from ownership lets founders keep control with a small stake, which can protect a long-term plan but can also entrench insiders.
  • Management proposes, the board oversees management and recommends how to vote, and shareholders vote at the meeting or by proxy.
  • Proxy advisors sell research and voting recommendations; asset managers vote the shares they manage and stay accountable to asset owners, who may set or keep voting policy themselves.
  • Good stewardship means treating proxy advice as one input judged against the manager's own policy and clients' interests.
  1. The situationFounders hold 20 million Class A shares with 10 votes each; the public holds 80 million Class B shares with 1 vote each.
  2. Step 1Founders' votes = 20 x 10 = 200 million; public votes = 80 x 1 = 80 million.
  3. Step 2Founders' share of votes = 200 / 280 = 71.4%, against an economic stake of 20 / 100 = 20%.
  4. Where questions turnExtra votes do not mean extra dividends or priority in liquidation; the classes usually share the same economic claim.
  5. The takeawayA 20% economic stake can carry over 70% of the votes, so outside holders cannot change the board.
Practise EQ.2

EQ.3Equity markets, trading venues and indexes

  • The primary market is where issuers sell new shares (an IPO, a seasoned offering, a private placement); the secondary market is where investors trade existing shares.
  • Exchanges match orders in a central book with published quotes; off-exchange venues (such as dark pools) match orders with little pre-trade display; OTC trading is negotiated with dealers and less transparent.
  • Float = shares outstanding - shares closely held or restricted (insiders, strategic holders, governments, locked-up shares).
  • Average daily volume = total shares traded over a period / number of trading days; with float and the bid-ask spread it measures liquidity.
  • Index weighting: price-weighted (by share price), market-capitalization-weighted (by market value, often float-adjusted), equal-weighted (same weight, tilts to small companies, needs rebalancing).
  • Indexes also differ by coverage: broad market, sector, style (value or growth) and size.
  1. The situationA company has 100 million shares outstanding, of which 40 million are held by insiders; average daily volume is 0.6 million shares.
  2. Step 1Float = 100 - 40 = 60 million shares.
  3. Step 2Daily turnover of float = 0.6 / 60 = 1.0%.
  4. Where questions turnFloat excludes every closely held block, not only insiders' shares: strategic and government stakes count too.
  5. The takeawayLiquidity is judged against the shares that can actually trade, not all shares outstanding.
Practise EQ.3

EQ.4Dividends, buybacks, splits and share returns

  • Returns come from price change and distributions: total return = (P1 - P0 + D) / P0; price return leaves out the dividend.
  • Cash dividends commit the company less flexibly than repurchases: dividends are expected to recur, while buybacks can be varied and let each shareholder choose whether to take cash.
  • Repurchases reduce shares outstanding and can raise EPS; whether they add value depends on the price paid.
  • A stock split (for example 2-for-1) raises the number of shares and lowers the price proportionally; a reverse split (for example 1-for-5) does the opposite; neither changes the company's value.
  • Dividend chronology: declaration date, ex-dividend date, record date, payment date. Buyers on or after the ex-dividend date do not receive the declared dividend, and the price usually falls by about the dividend that day.
  1. The situationA share bought at USD 50 pays a USD 2 dividend and is worth USD 54 a year later.
  2. Step 1Price return = (54 - 50) / 50 = 8.0%.
  3. Step 2Total return = (54 - 50 + 2) / 50 = 12.0%.
  4. Where questions turnThe ex-dividend date, not the record date, decides who gets the dividend when buying in the market.
  5. The takeawayTotal return adds the income to the price change; the dividend here adds 4 percentage points.
Practise EQ.4

EQ.5Price, value and families of valuation models

  • Price is what the market charges; intrinsic value is the analyst's estimate of what the share is worth. Value above price suggests undervaluation, below price overvaluation.
  • Book value of equity is an accounting measure based on historical cost; market capitalization (shares x price) is the market's view of equity; enterprise value = market capitalization + debt + preferred + minority interest - cash.
  • Enterprise value measures the whole business independent of financing, so it suits comparisons of companies with different leverage.
  • Present value models discount expected future cash flows (dividends, FCFE, FCFF, residual income) and give intrinsic value but need long forecasts.
  • Multiples models compare price with a fundamental (earnings, sales, book value, EBITDA) against peers; they are quick but give relative value and inherit any market mispricing.
  • Asset-based models value the assets less liabilities; they suit holding companies, natural resource firms and liquidations, not firms whose value is intangible.
  1. The situationA company has a market capitalization of USD 900 million, debt of USD 400 million and cash of USD 100 million.
  2. Step 1Enterprise value = 900 + 400 - 100 = USD 1,200 million.
  3. Step 2Equity is 75% of enterprise value (900 / 1,200).
  4. Where questions turnCash is subtracted, not added, when moving from market capitalization to enterprise value.
  5. The takeawayEnterprise value is the price of the whole operating business; equity is only the residual part of it.
Practise EQ.5

EQ.6Present value models for shares

  • Dividend discount model: value = present value of expected dividends at the required return on equity. FCFE is discounted at the cost of equity and gives equity value directly; FCFF is discounted at the WACC and gives firm value, from which debt is subtracted.
  • Residual income models add to book value the present value of earnings above the equity charge.
  • Constant growth (Gordon): V0 = D1 / (r - g) = D0 x (1 + g) / (r - g), valid only when g is stable and below r.
  • Multistage: discount the forecast dividends of the high-growth years, then add a terminal value Pn = Dn+1 / (r - g) discounted back n years.
  • Value is very sensitive to r - g; constant growth forever and an abrupt switch between stages are simplifications.
  • A non-callable, non-convertible preferred share is a perpetuity: V = D / r. A call feature lowers value; a put or conversion right raises it.
  1. The situationA company just paid a dividend of USD 1.50, dividends grow at 5% forever and the required return is 10%.
  2. Step 1Next dividend D1 = 1.50 x 1.05 = 1.575.
  3. Step 2V0 = 1.575 / (0.10 - 0.05) = USD 31.50.
  4. Where questions turnThe terminal value at year n uses the dividend of year n + 1 and is discounted n years, not n + 1.
  5. The takeawayUse next year's dividend in the numerator; growing the dividend once is the step most often missed.
Practise EQ.6

EQ.7Valuing shares with price and EV multiples

  • Method of comparables: apply a benchmark multiple (often a peer median) to the company's own fundamental, assuming peers are fairly priced.
  • Method of forecasted fundamentals: derive a justified multiple from a valuation model, for example justified forward P/E = payout ratio / (r - g); justified trailing P/E multiplies that by (1 + g).
  • Price multiples: P/E, P/B (useful for banks), P/S (useful when earnings are negative), P/CF. Enterprise value multiples such as EV/EBITDA and EV/sales compare businesses with different leverage.
  • Match numerator and denominator: equity value with equity measures (earnings), enterprise value with firm measures (EBITDA, sales).
  • Peers come from an industry classification, refined by business model, growth, margins and risk.
  • Trailing multiples use the last twelve months; forward multiples use forecasts and suit companies whose earnings are changing.
  1. The situationPeers trade at a median P/E of 15x, and the company's EPS is USD 2.40.
  2. Step 1Estimated value = 15 x 2.40 = USD 36.00.
  3. Step 2If the share trades at USD 30.00, it looks undervalued relative to peers.
  4. Where questions turnDividing EBITDA into market capitalization instead of enterprise value mixes equity and firm measures.
  5. The takeawayComparables give relative value: if the whole peer group is overpriced, so is the estimate.
Practise EQ.7

EQ.8Building forecast models to value equity

  • A forecast model projects the income statement, balance sheet and cash flow statement together, starting from revenue.
  • Revenue can be built top-down (market size x share) or bottom-up (volume x price, segments, stores).
  • Costs, working capital and capital spending are tied to revenue drivers so growth assumptions flow through to cash flow.
  • A balancing item, usually cash or a revolving credit line, keeps the balance sheet in balance.
  • The model's design should match the company: a bank needs loans and deposits, a retailer needs store counts and same-store sales.
  • Model outputs (free cash flow, earnings) feed present value or multiples valuations; scenarios test how sensitive value is to key drivers.
  1. The situationRevenue is GBP 1,000 million, expected to grow 5%, with an EBIT margin of 20%.
  2. Step 1Forecast revenue = 1,000 x 1.05 = 1,050.
  3. Step 2Forecast EBIT = 1,050 x 0.20 = GBP 210 million.
  4. Where questions turnForecasting costs or capital spending without linking them to revenue gives a model whose cash flow ignores its own growth.
  5. The takeawayEach line is a driver applied to revenue, so the revenue forecast moves every other number.
Practise EQ.8

EQ.9Analysing industries and competitive forces

  • Industry analysis: define the industry, measure its size, growth and profitability, assess its structure and external influences, then position the company.
  • Classification: commercial systems group companies by principal business activity; companies can also be grouped by sensitivity to the business cycle (cyclical or defensive) or by statistical similarity of returns.
  • Market share = company sales / industry sales; a falling share in a growing market means the company is losing ground.
  • Porter's five forces: threat of entry, power of suppliers, power of buyers, threat of substitutes, rivalry. Weak forces support higher profitability.
  • PESTLE: political, economic, social, technological, legal and environmental influences from outside the industry.
  • Life cycle: embryonic, growth, shakeout, mature, decline; maturity brings slow growth, consolidation and price competition.
  1. The situationIndustry sales rise from USD 2.0 billion to 2.2 billion; the company's sales rise from USD 300 million to 308 million.
  2. Step 1Industry growth = 2.2 / 2.0 - 1 = 10%.
  3. Step 2Market share falls from 300 / 2,000 = 15% to 308 / 2,200 = 14%.
  4. Where questions turnA tax or regulation change is political or legal, a change in tastes is social: classify the factor by its source.
  5. The takeawayThe company grew, but slower than its market, so it lost share.
Practise EQ.9

EQ.10Company strategy, drivers and capital needs

  • Competitive strategy: cost leadership, differentiation or a focus on a niche; position shows in margins and returns relative to peers.
  • Revenue drivers: volume, price and mix. Pricing power means raising prices faster than costs or inflation without losing volume.
  • Operating leverage: with high fixed costs, operating profit moves more than revenue; financial leverage does the same for net income through fixed interest.
  • Working capital: cash conversion cycle = days of inventory + days of receivables - days of payables; a shorter cycle needs less financing.
  • Capital investment: maintenance spending keeps capacity; growth spending adds it. Returns on invested capital above the cost of capital create value.
  • Capital structure affects risk and the cost of capital; compare leverage and coverage with peers and with the stability of cash flow.
  1. The situationReceivables are CAD 120 million on annual revenue of CAD 1,095 million; days of inventory are 50 and days of payables 30.
  2. Step 1Days of receivables = 120 / (1,095 / 365) = 120 / 3 = 40 days.
  3. Step 2Cash conversion cycle = 50 + 40 - 30 = 60 days.
  4. Where questions turnA margin rise from spreading fixed costs over more volume is operating leverage, not pricing power.
  5. The takeawayCollecting faster or paying suppliers later shortens the cycle and frees cash.
Practise EQ.10

EQ.11Writing and reading equity research

  • A full company report covers the investment thesis, the business and industry, financial analysis and forecasts, valuation, risks, and a recommendation or target price.
  • Sell-side analysts work for brokers and publish to clients, usually with ratings and target prices; buy-side analysts work for asset managers and write for their own portfolio decisions.
  • Conflicts of interest are a particular concern in sell-side research and must be disclosed.
  • Analysts using the same model can reach different values because they assume different revenue growth, margins, reinvestment and financing.
  • Good reports state their key assumptions and show how value changes with them (sensitivity or scenario analysis).
  1. The situationTwo analysts value a company at next year's free cash flow of 100 / (r - g) with r = 9%; one assumes g = 3%, the other 4%.
  2. Step 1Analyst A: 100 / 0.06 = 1,666.7.
  3. Step 2Analyst B: 100 / 0.05 = 2,000, about 20% higher.
  4. Where questions turnWide distribution and public ratings belong to sell-side research, not buy-side.
  5. The takeawayOne percentage point of growth moves value by a fifth, so assumptions, not the model, explain most disagreements.
Practise EQ.11

EQ.12CAPM and factor models for required return

  • CAPM: required return = rf + beta x (E(Rm) - rf), where E(Rm) - rf is the market (equity) risk premium.
  • Beta measures sensitivity to the market and is usually estimated with the market model: Ri = alpha + beta x Rm + error; the slope is beta, the intercept alpha.
  • Only systematic risk is priced; specific risk can be diversified away.
  • Arbitrage pricing theory: expected return = rf + the sum of factor sensitivities x factor risk premiums; it rests on no-arbitrage and allows several systematic factors.
  • Multi-factor models (for example market, size, value, momentum, or macroeconomic factors) explain returns better than one factor and are used to build and analyse portfolios.
  1. The situationThe risk-free rate is 4%, the equity risk premium is 5% and a share's beta is 1.1.
  2. Step 1Risk premium for the share = 1.1 x 5% = 5.5%.
  3. Step 2Required return = 4% + 5.5% = 9.5%.
  4. Where questions turnMultiply beta by the risk premium, not by the market return, unless the risk-free rate is subtracted first.
  5. The takeawayThe CAPM adds beta times the premium to the risk-free rate; it is the discount rate for equity cash flows.
Practise EQ.12

Key terms

Float
Shares available to trade: shares outstanding less closely held and restricted shares.
Ex-dividend date
The first day a share trades without the right to the declared dividend.
Enterprise value
Market capitalization plus debt, preferred and minority interest, less cash.
Intrinsic value
An analyst's estimate of a share's worth from its expected cash flows and risk.
Gordon growth model
Value equals next year's dividend divided by the required return less a constant growth rate.
Justified multiple
A multiple derived from fundamentals such as payout, required return and growth.
Five forces
Entry, suppliers, buyers, substitutes and rivalry, which together shape industry profitability.
Cash conversion cycle
Days of inventory plus days of receivables less days of payables.
Beta
A share's sensitivity to market returns, the slope of the market model.
Arbitrage pricing theory
A no-arbitrage model pricing several systematic risk factors.

After this guide: You should be able to describe share types, markets and returns, value a share with dividend, preferred and multiples models, and estimate a required return with the CAPM.

Practise Equities

Built to the topics and weights CFA Institute publishes for the 2027 Level I curriculum. The module names, explanations, worked examples and traps are ExamDragon's own. Every source this path is built on.