Equity Investments

    Exam weight 11–14%
    168 questions in the bank
    8 subtopics

    Equity splits into market mechanics and valuation. The mechanics half is detail-heavy and quick to score; the valuation half is where the marks are won, and it leans almost entirely on the discounting you learned in Quant.

    What you need to be able to do

    • Apply the dividend discount model, and know when its assumptions break
    • Choose between price multiples and justify the choice
    • Distinguish the three forms of market efficiency by what information is already priced
    • Read an index methodology and predict its biases

    Where candidates lose marks

    Applying the Gordon growth model when the growth rate is not sustainable, or exceeds the required return, which makes the formula meaningless rather than merely wrong.

    10 free Equity practice questions

    Real questions from the CFAQuiz bank, one or two per subtopic, with the full explanation. No account needed.

    1
    Equity Securities
    medium
    EQ-ES-01

    An investor buys a common share for $40, receives a $1.20 dividend, and sells the share one year later for $46. What is the investor’s holding period return (HPR)?

    1. A.15.00%
    2. B.3.00%
    3. C.18.00%
    Show answer and explanation

    Correct answer: C

    Compute capital gains yield and dividend yield, then sum to get HPR.

    Capital gains yield:

    46−4040=0.15=15.00%\frac{46 - 40}{40} = 0.15 = 15.00\%

    Dividend yield:

    1.2040=0.03=3.00%\frac{1.20}{40} = 0.03 = 3.00\%

    Holding period return:

    0.15+0.03=0.18=18.00%0.15 + 0.03 = 0.18 = 18.00\%
    • Option A omits the dividend:
    46−4040=0.15=15.00%\frac{46 - 40}{40} = 0.15 = 15.00\%
    • Option B uses only the dividend yield:
    1.2040=0.03=3.00%\frac{1.20}{40} = 0.03 = 3.00\%
    2
    Equity Valuation: DDM
    medium
    EQ_DDM_01

    A company just paid a dividend of $2.00 per share. Dividends are expected to grow at 4% indefinitely. The required return on equity is 9%. Using the Gordon growth DDM, what is the intrinsic value per share today?

    1. A.$23.11
    2. B.$40.00
    3. C.$41.60
    Show answer and explanation

    Correct answer: C

    Compute next year's dividend and apply the Gordon growth model.

    D1=D0×(1+g)=2.00×1.04=2.08D_1 = D_0 \times (1+g) = 2.00 \times 1.04 = 2.08 V0=D1r−g=2.080.09−0.04=2.080.05=41.60V_0 = \frac{D_1}{r - g} = \frac{2.08}{0.09 - 0.04} = \frac{2.08}{0.05} = 41.60
    • Option A uses the required return instead of the spread (r−g)(r-g) in the denominator:
    D1r=2.080.09=23.11\frac{D_1}{r} = \frac{2.08}{0.09} = 23.11
    • Option B uses D0D_0 instead of D1D_1:
    D0r−g=2.000.05=40.00\frac{D_0}{r - g} = \frac{2.00}{0.05} = 40.00
    3
    Equity Valuation: Multiples
    medium
    EQV.MULT.05

    An analyst plans to use a peer-based P/E to value Firm Q. The peer group’s P/E ratios are 12, 18, and 24. The forecast EPS for Firm Q next year is $3.00. Using the harmonic mean P/E for the peers, what is the implied target price for Firm Q?

    1. A.$54.00
    2. B.$51.92
    3. C.$49.85
    Show answer and explanation

    Correct answer: C

    First compute the harmonic mean P/E, then multiply by EPS.

    HMP/E=n∑(1/PEi)=3112+118+124\text{HM}_{P/E} = \frac{n}{\sum (1/PE_i)} = \frac{3}{\frac{1}{12} + \frac{1}{18} + \frac{1}{24}} ∑(1/PEi)=0.0833333+0.0555556+0.0416667=0.1805556\sum (1/PE_i) = 0.0833333 + 0.0555556 + 0.0416667 = 0.1805556 HMP/E=30.1805556=16.6153846\text{HM}_{P/E} = \frac{3}{0.1805556} = 16.6153846 P0=16.6153846×3.00=49.8461538⇒49.85P_0 = 16.6153846 \times 3.00 = 49.8461538 \Rightarrow 49.85
    • Option A uses the arithmetic mean P/E instead of the harmonic mean:
    P/Eˉ=12+18+243=18\bar{P/E} = \frac{12 + 18 + 24}{3} = 18 18×3.00=54.0018 \times 3.00 = 54.00
    • Option B uses the geometric mean P/E instead of the harmonic mean:
    GMP/E=(12×18×24)1/3=51841/3=17.30699\text{GM}_{P/E} = (12 \times 18 \times 24)^{1/3} = 5184^{1/3} = 17.30699 17.30699×3.00=51.9217.30699 \times 3.00 = 51.92
    4
    Industry and Company Analysis
    medium
    EQ-ICA-05

    Within Porter’s five forces framework, which industry condition most likely increases rivalry and reduces average industry profitability?

    1. A.High switching costs for buyers
    2. B.Significant product differentiation and strong brand loyalty
    3. C.Excess industry capacity with high exit barriers
    Show answer and explanation

    Correct answer: C

    Excess capacity combined with high exit barriers intensifies competitive rivalry as firms cut prices to utilize capacity and cannot easily leave the industry.

    • Option A is incorrect because high switching costs reduce buyers’ propensity to switch, easing price competition.
    • Option B is incorrect because strong differentiation and brand loyalty reduce direct price competition among incumbents.
    5
    Market Efficiency
    medium
    EQ.ME.1

    An event study in a large, developed equity market finds that stock prices fully reflect earnings surprises within minutes of the public announcement, with no subsequent drift. However, enforcement cases show insiders trading on material, nonpublic information can consistently earn abnormal profits. Which statement about market efficiency is most accurate for this market?

    1. A.Only weak-form efficiency holds.
    2. B.Strong-form efficiency holds.
    3. C.The market is semi-strong-form efficient but not strong-form efficient.
    Show answer and explanation

    Correct answer: C

    Prices adjust rapidly to public announcements with no post-announcement drift, indicating that public information is quickly incorporated into prices. That is the defining implication of semi-strong-form efficiency. However, if insiders with material, nonpublic information can earn abnormal profits, strong-form efficiency is violated. Therefore, the market is semi-strong-form efficient but not strong-form efficient.

    • Option A is wrong: saying only weak-form efficiency holds ignores the evidence that public information is impounded quickly; weak-form speaks only to past prices, not public announcements.
    • Option B is wrong: strong-form efficiency would preclude insiders from earning abnormal profits using nonpublic information, which contradicts the evidence.
    6
    Market Organization
    hard
    EQ-MO-6

    The ask side of a limit order book is shown below. A market buy order for 1,500 shares arrives. What is the volume-weighted average execution price per share, to the nearest $0.01?

    Shares at AskPrice
    20025.10
    30025.13
    1,30025.16
    1. A.$25.13
    2. B.$25.15
    3. C.$25.12
    Show answer and explanation

    Correct answer: B

    Fill 200 at 25.10, 300 at 25.13, and 1,000 at 25.16. Compute total cost and divide by 1,500 shares.

    200×25.10=5,020200 \times 25.10 = 5{,}020 300×25.13=7,539300 \times 25.13 = 7{,}539 1,000×25.16=25,1601{,}000 \times 25.16 = 25{,}160 Total cost=5,020+7,539+25,160=37,719\text{Total cost} = 5{,}020 + 7{,}539 + 25{,}160 = 37{,}719 VWAP=37,7191,500=25.146⇒25.15\text{VWAP} = \frac{37{,}719}{1{,}500} = 25.146 \Rightarrow 25.15
    • Option A takes a simple (unweighted) average of price levels:
    25.10+25.13+25.163=25.13\frac{25.10 + 25.13 + 25.16}{3} = 25.13
    • Option C averages only the first two levels (ignores the partial fill at the third level):
    5,020+7,539500=25.118⇒25.12\frac{5{,}020 + 7{,}539}{500} = 25.118 \Rightarrow 25.12
    7
    Security Market Indexes
    medium
    EQ-SMI-05

    Which index weighting scheme typically requires the most frequent rebalancing to maintain its target weights?

    1. A.Price-weighted index
    2. B.Value-weighted (market-cap-weighted) index
    3. C.Equal-weighted index
    Show answer and explanation

    Correct answer: C

    Equal-weighted indexes require periodic rebalancing to restore each constituent to the same weight as prices move away from equality.

    • Option A: Price-weighted indexes do not rebalance to target weights; their weights drift mechanically with price and only the divisor is adjusted for splits, stock dividends, or composition changes.
    • Option B: Value-weighted indexes are largely self-rebalancing; weights evolve with market caps and typically involve the least turnover between scheduled reconstitutions.
    8
    Equity Securities
    easy
    EQ-ES-05

    A convertible preferred share can be converted into 4 common shares. The preferred currently trades at $106. What is the parity price per common share (the common share price that makes the conversion value equal to the preferred’s market price)?

    1. A.21.20
    2. B.424.00
    3. C.26.50
    Show answer and explanation

    Correct answer: C

    Parity price per common share equals the preferred price divided by the conversion ratio:

    Parity price=1064=26.50\text{Parity price} = \frac{106}{4} = 26.50
    • Option A divides by (ratio + 1), incorrectly adding a share that does not exist:
    1065=21.20\frac{106}{5} = 21.20
    • Option B multiplies by the conversion ratio, producing a total-equivalent value rather than a per-share price:
    106×4=424.00106 \times 4 = 424.00
    9
    Equity Valuation: DDM
    hard
    EQ_DDM_02

    A firm just paid a dividend of $1.50 per share. Dividends will grow at 15% for the next two years and then at 5% in perpetuity. The required return is 10%. What is the intrinsic value per share today?

    1. A.$37.64
    2. B.$36.00
    3. C.$32.71
    Show answer and explanation

    Correct answer: A

    High growth for years 1–2, then constant growth from year 3 onward.

    D1=1.50×1.15=1.7250D_1 = 1.50 \times 1.15 = 1.7250 D2=1.7250×1.15=1.98375D_2 = 1.7250 \times 1.15 = 1.98375 D3=1.98375×1.05=2.0829375D_3 = 1.98375 \times 1.05 = 2.0829375 P2=D3r−gL=2.08293750.10−0.05=2.08293750.05=41.65875P_2 = \frac{D_3}{r - g_L} = \frac{2.0829375}{0.10 - 0.05} = \frac{2.0829375}{0.05} = 41.65875

    Present values:

    PV(D1)=1.72501.10=1.568181818PV(D_1) = \frac{1.7250}{1.10} = 1.568181818 PV(D2)=1.983751.102=1.983751.21=1.639462810PV(D_2) = \frac{1.98375}{1.10^2} = \frac{1.98375}{1.21} = 1.639462810 PV(P2)=41.658751.21=34.433884298PV(P_2) = \frac{41.65875}{1.21} = 34.433884298 V0=1.568181818+1.639462810+34.433884298=37.641528926≈37.64V_0 = 1.568181818 + 1.639462810 + 34.433884298 = 37.641528926 \approx 37.64
    • Option B uses D2D_2 instead of D3D_3 in the terminal value:
    P2wrong=D2r−gL=1.983750.05=39.675P_2^{\text{wrong}} = \frac{D_2}{r-g_L} = \frac{1.98375}{0.05} = 39.675 PV(P2wrong)=39.6751.21=32.79338843PV(P_2^{\text{wrong}}) = \frac{39.675}{1.21} = 32.79338843 V0wrong=1.568181818+1.639462810+32.79338843=36.00103306≈36.00V_0^{\text{wrong}} = 1.568181818 + 1.639462810 + 32.79338843 = 36.00103306 \approx 36.00
    • Option C starts with D0D_0 as if it were D1D_1:
    D1wrong=1.50, D2wrong=1.50×1.15=1.725, D3wrong=1.725×1.05=1.81125D_1^{\text{wrong}} = 1.50,\ D_2^{\text{wrong}} = 1.50\times1.15 = 1.725,\ D_3^{\text{wrong}} = 1.725\times1.05 = 1.81125 P2wrong=1.811250.05=36.225P_2^{\text{wrong}} = \frac{1.81125}{0.05} = 36.225 PV=1.501.10+1.7251.21+36.2251.21=1.36363636+1.425619835+29.925619835=32.71487603≈32.71PV = \frac{1.50}{1.10} + \frac{1.725}{1.21} + \frac{36.225}{1.21} = 1.36363636 + 1.425619835 + 29.925619835 = 32.71487603 \approx 32.71
    10
    Equity Valuation: Multiples
    medium
    EQV.MULT.02

    A firm has ROE of 12.0%, a dividend payout ratio of 40%, and a required return on equity of 9.5%. Using the Gordon growth framework, what is the justified leading P/E ratio?

    1. A.17.39
    2. B.18.78
    3. C.26.09
    Show answer and explanation

    Correct answer: A

    Compute sustainable growth and then the justified leading P/E: P0/E1=1−br−gP_0/E_1 = \frac{1 - b}{r - g}.

    b=1−0.40=0.60b = 1 - 0.40 = 0.60 g=b×ROE=0.60×0.12=0.072g = b \times \text{ROE} = 0.60 \times 0.12 = 0.072 P0/E1=0.400.095−0.072=0.400.023=17.39P_0/E_1 = \frac{0.40}{0.095 - 0.072} = \frac{0.40}{0.023} = 17.39
    • Option B applies the trailing P/E formula (multiplying by 1+g1+g) instead of leading:
    P0/E0=0.40(1+0.072)0.095−0.072=0.42880.023=18.78P_0/E_0 = \frac{0.40(1+0.072)}{0.095 - 0.072} = \frac{0.4288}{0.023} = 18.78
    • Option C incorrectly uses the retention ratio in the numerator instead of the payout:
    br−g=0.600.095−0.072=0.600.023=26.09\frac{b}{r - g} = \frac{0.60}{0.095 - 0.072} = \frac{0.60}{0.023} = 26.09

    158 more Equity questions

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