NISM CFA Level 1, Equity Investments. Updated Jun 2026, 13-minute read.

CFA Level 1 Equity Valuation — DDM, P/E, P/B, and EV Multiples

Q: What's the difference between P/E and EV/EBITDA for valuation?

P/E uses equity value (market cap) and is affected by a company's capital structure (leverage increases EPS volatility). EV/EBITDA uses enterprise value (market cap + debt − cash) and is capital-structure neutral. EV/EBITDA is preferred when comparing companies with different leverage levels, or in industries where EBITDA is a better cash flow proxy than EPS. P/E is simpler and more widely cited in media, but EV/EBITDA is more analytically rigorous.

Q: How does CFA Level 1 equity content differ from Level 2?

Level 1 tests conceptual understanding — knowing the DDM formula, understanding EMH, identifying P/E use cases. Level 2 applies these deeply — you'll build full DDM models from scratch, calculate FCFF vs FCFE from financial statements, apply multi-stage growth models, and use residual income models. Level 1 is learning the vocabulary; Level 2 is using it in full sentences.

Equity Investments is 11–14% of CFA Level 1 (~20 questions). The emphasis is on understanding market structure, security market indexes, the Efficient Market Hypothesis, and foundational equity valuation models. Level 1 tests concepts; Level 2 tests deep application of these same models.

Key takeaways

Efficient Market Hypothesis (EMH): Weak form (prices reflect past data), Semi-strong (all public info), Strong (all public + private info)
DDM (Gordon Growth Model): P₀ = D₁ / (r − g) — requires r > g and constant growth assumption
FCFE valuation: P₀ = FCFE₁ / (r − g) — more flexible than DDM; applies when dividends ≠ FCFE
P/E ratio: Leading P/E = Price / Next Year's EPS; Trailing P/E = Price / Last Year's EPS
P/B ratio: Market value of equity / Book value of equity — below 1.0 may signal undervaluation or value trap
EV/EBITDA: Enterprise Value / EBITDA — capital-structure neutral; useful for comparing leveraged firms
Industry classification: GICS (Global Industry Classification Standard) — 11 sectors, 24 industry groups

Market Efficiency — EMH

The Efficient Market Hypothesis (EMH) holds that security prices fully reflect available information.

Weak Form: Prices reflect all past price and volume data. Technical analysis cannot generate persistent alpha. Tests: autocorrelation tests, filter rules.
Semi-Strong Form: Prices reflect all publicly available information (financial statements, news, analyst reports). Fundamental analysis cannot generate persistent excess returns. Tests: event studies.
Strong Form: Prices reflect all public AND private information (including insider information). Even insiders cannot consistently earn abnormal returns. Tests: performance of insiders, mutual fund managers.

Exam insight: Most empirical evidence supports weak and semi-strong forms. Strong form is generally rejected — insider trading laws exist precisely because insiders can profit from MNPI.

Anomalies that challenge EMH: momentum (contradicts weak form), post-earnings announcement drift (contradicts semi-strong), calendar effects (January effect).

Dividend Discount Model (DDM)

Value = Present Value of all future dividends.

Gordon Growth Model (Constant Growth DDM)

P₀ = D₁ / (k − g)

D₁ = Next period's dividend = D₀ × (1 + g)
k = Required rate of return (from CAPM: k = Rf + β × Market Risk Premium)
g = Sustainable growth rate = ROE × Retention ratio = ROE × (1 − Payout ratio)
Condition: k > g (model breaks down if g ≥ k)

Example: D₀ = ₹10, g = 8%, k = 12%. P₀ = 10 × 1.08 / (0.12 − 0.08) = 10.80 / 0.04 = ₹270

Two-Stage DDM

For firms with high growth that then normalises:

Calculate PV of dividends in high-growth period (each year separately)
At end of high-growth period, apply Gordon Growth Model for terminal value
PV total = PV of high-growth dividends + PV of terminal value

Free Cash Flow to Equity (FCFE)

FCFE = Net Income + D&A − CapEx − Change in Working Capital + Net Borrowing

Or: FCFE = CFO − CapEx + Net Borrowing

Valuation: P₀ = FCFE₁ / (k − g)

When to use FCFE vs DDM: FCFE when dividends don't reflect firm's cash generation capacity (company retains a lot, or pays special dividends). DDM when dividends are stable and reflect payout policy. FCFE is more useful for non-dividend-paying firms.

Price Multiples

P/E Ratio (Price-to-Earnings)

Type	Formula	Use
Trailing P/E	Price / EPS (last 12 months)	Based on known earnings — more stable
Leading P/E	Price / Forecasted EPS (next 12 months)	Forward-looking; used in DCF context
Justified P/E	D₁/E₁ / (k − g) = Payout / (k − g)	What P/E should be given fundamentals

P/E limitations: Not useful when EPS is negative. Cyclical businesses have misleading P/E at earnings extremes. Different accounting choices affect comparability.

P/B Ratio (Price-to-Book)

P/B = Market Price per Share / Book Value per Share

Useful for: financial firms (banks, insurance) where book value closely tracks asset values.

P/B < 1.0: Market values firm below net assets — could be undervalued or signal structural problems (low ROE, write-off risk).

Justified P/B = (ROE − g) / (k − g)

EV/EBITDA

Enterprise Value (EV) = Market Cap + Total Debt − Cash and Cash Equivalents

EV/EBITDA is capital-structure neutral — unaffected by leverage differences between firms. Useful for comparing firms with different debt levels or in leveraged buyout (LBO) analysis.

Limitation: EBITDA ignores CapEx — a capital-intensive firm with high EBITDA but also high CapEx is less valuable than it appears.

Industry Analysis Framework

Five Forces (Porter) — used in CFA Level 1 industry analysis:

Threat of new entrants (barriers to entry: capital, regulation, brand, economies of scale)
Bargaining power of buyers
Bargaining power of suppliers
Threat of substitutes
Rivalry among existing competitors

Industry life cycle: Embryonic → Growth → Shakeout → Mature → Decline. Mature industries are most amenable to dividend-paying analysis; embryonic/growth firms use FCFE or P/S multiples.

Frequently asked questions

What's the difference between P/E and EV/EBITDA for valuation?