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CFA Level I Equity Investments Practice Questions

Official outline
CFA Institute 2026 Level I Topic Outlines (learning outcomes)
Questions on this page
7
Updated
Nov 3, 2026
Share of the exam
11-14%

  1. Question 1, hard

    A stock has a required return of 10%, an expected long-term dividend growth rate of 6%, and an expected dividend payout ratio of 40%. Using the Gordon growth model, what is the stock's justified leading (forward) P/E ratio?

    • A.10.0x
    • B.6.67x
    • C.4.0x
    • D.15.0x
    Show answer and explanationHide answer

    Correct answer: A. 10.0x

    The justified leading P/E from the Gordon growth model is: Payout ratio / (r − g) = 0.40 / (0.10 − 0.06) = 0.40 / 0.04 = 10.0x. This shows how a valuation multiple can be derived directly from fundamentals: payout policy, required return, and growth.

    • A. Justified leading P/E = payout ratio / (r - g) = 0.40 / (0.10 - 0.06) = 0.40 / 0.04 = 10.0x.
    • B. 6.67x comes from dividing the payout ratio by the growth rate alone (0.40 / 0.06) instead of by the required return minus growth spread of 4%.
    • C. 4.0x comes from dividing the payout ratio by the required return (0.40 / 0.10) instead of by the (r - g) spread. This ignores growth in the denominator and understates the multiple.
    • D. 15.0x comes from using the retention ratio (1 - 0.40 = 0.60) in the numerator instead of the payout ratio (0.60 / 0.04). The leading P/E is based on the dividend payout, not the earnings retained.

  2. Question 2, medium

    An operating company has $500 million market capitalization, $120 million interest-bearing debt, $30 million preferred equity, $10 million noncontrolling interest, and $40 million excess cash. Its annual EBITDA is $100 million. What EV/EBITDA multiple is implied?

    • A.6.2x.
    • B.5.8x.
    • C.4.6x.
    • D.7.0x.
    Show answer and explanationHide answer

    Correct answer: A. 6.2x.

    Enterprise value = market cap + debt + preferred + noncontrolling interest - excess cash = 500 + 120 + 30 + 10 - 40 = $620 million. EV/EBITDA = 620/100 = 6.2x.

    • A. EV of $620 million divided by EBITDA of $100 million is 6.2x.
    • B. This omits preferred equity and noncontrolling interest from enterprise value.
    • C. This omits debt, preferred and noncontrolling interest, effectively using equity less cash.
    • D. This adds excess cash instead of subtracting it.

  3. Question 3, hard

    A company has a sustainable ROE of 15%, a dividend payout ratio of 40%, and shareholders require a 12% return. Using the fundamental (Gordon growth-based) justified leading P/E formula, the justified P0/E1 multiple is closest to:

    • A.13.33x
    • B.14.53x
    • C.3.33x
    • D.6.67x
    Show answer and explanationHide answer

    Correct answer: A. 13.33x

    Retention ratio b = 1 − 0.40 = 0.60, so g = b × ROE = 0.60 × 0.15 = 9%. Justified leading P/E = payout ratio / (r − g) = 0.40 / (0.12 − 0.09) = 13.33x. B (14.53x) results from applying the trailing P/E formula, which grows the payout by (1+g), instead of the leading formula the question asks for. C (3.33x) comes from forgetting to net out growth (0.40/0.12). D (6.67x) comes from mistakenly discounting at ROE instead of the required return r (0.40/(0.15−0.09)).

    • A. g = ROE x (1-payout) = 15% x 0.60 = 9%; justified leading P0/E1 = payout/(r-g) = 0.40/(0.12-0.09) = 0.40/0.03 = 13.33x.
    • B. 14.53x equals payout x (1+g)/(r-g) = 0.40 x 1.09/0.03, which is the justified trailing (P0/E0) multiple, not the leading (P0/E1) multiple the question asks for.
    • C. 3.33x equals payout/r (0.40/0.12), mistakenly dividing by the full required return alone and ignoring the growth-rate adjustment in the denominator.
    • D. 6.67x results from miscalculating growth as ROE x payout (15% x 0.40 = 6%) instead of ROE x (1-payout), understating growth and overstating the (r-g) spread.

  4. Question 4, easy

    One component company in a price-weighted stock index executes a 2-for-1 stock split, with no change in the company's total market capitalization. All else equal, immediately after the split:

    • A.The index level rises immediately, because the number of the company's shares outstanding doubles
    • B.The index provider must remove the stock and replace it with a different company
    • C.The stock's weight in the index increases, requiring the divisor to be adjusted upward
    • D.The index level is unaffected, because the index divisor is recalculated to offset the drop in that stock's price
    Show answer and explanationHide answer

    Correct answer: D. The index level is unaffected, because the index divisor is recalculated to offset the drop in that stock's price

    In a price-weighted index, a component's stock split lowers that stock's price per share (here, roughly by half), which would otherwise distort the index level even though nothing economically changed. To neutralize this, index providers recalculate the divisor immediately so the index level is unaffected by the mechanical price change from the split.

    • A. Incorrect. Shares outstanding doubling does not, by itself, change the price-weighted index level; the divisor absorbs the price change.
    • B. Incorrect. Stock splits are routine and do not trigger removal from an index; the divisor mechanism handles them.
    • C. Incorrect. A split lowers, not raises, the stock's per-share price and thus its weight in a price-weighted index.
    • D. Correct. The divisor is recalculated specifically to keep the index level unchanged when a split alone (with no economic change) occurs.

  5. Question 5, medium

    Company X trades at 18 times earnings and has a sustainable ROE of 18%, while comparable Y trades at 12 times earnings with ROE 8%. Why might X reasonably command a higher P/E despite similar growth?

    • A.P/E rankings across the two firms reveal the relative cost of debt each faces
    • B.Greater profitability relative to required equity capital can justify a higher multiple
    • C.A higher ROE means X's shares are underpriced relative to Y's because the market has missed it
    • D.Higher ROE signals that accounting earnings will decline next year as returns revert
    Show answer and explanationHide answer

    Correct answer: B. Greater profitability relative to required equity capital can justify a higher multiple

    Multiples reflect profitability, reinvestment, growth, and risk. A higher ROE relative to the required return can justify a higher P/E but does not by itself prove mispricing.

    • A. A P/E ratio reflects equity valuation drivers and does not reveal a firm's cost of debt.
    • B. ROE well above the required return on equity supports a justified premium multiple.
    • C. A justified premium for higher ROE is not evidence of underpricing; the market may already price it fairly.
    • D. A high ROE does not signal declining earnings; it relates to profitability on equity capital.

  6. Question 6, easy

    A firm starts the year with book value per share $40, has expected EPS $6 and cost of equity 10%. What is the expected residual income per share for the year?

    • A.$6
    • B.$10
    • C.$2
    • D.$4
    Show answer and explanationHide answer

    Correct answer: C. $2

    Residual income equals earnings less an equity charge: $6 - (10% x $40) = $2 per share.

    • A. This is EPS alone, ignoring the charge for the cost of equity capital.
    • B. This is not derived from the inputs; it looks like the book value multiplied by a rate misapplied.
    • C. EPS of $6 minus the $4 equity charge leaves $2.
    • D. This is the equity charge itself, not the residual after subtracting it from earnings.

  7. Question 7, easy

    An analyst claims that current stock prices fully reflect all publicly available information. Including historical prices, published financial statements, and public news announcements. But not private, non-public (insider) information. Under the Fama market efficiency framework used in the CFA curriculum, this describes:

    • A.Weak-form efficiency
    • B.Allocative efficiency
    • C.Strong-form efficiency
    • D.Semi-strong-form efficiency
    Show answer and explanationHide answer

    Correct answer: D. Semi-strong-form efficiency

    Semi-strong-form efficiency holds that prices reflect all publicly available information, both historical market data and public non-market information (financial statements, news, announcements), such that fundamental and technical analysis of public information cannot generate consistent abnormal returns. Weak-form efficiency covers only historical price and volume data; strong-form efficiency additionally includes private/insider information.

    • A. Incorrect. Weak-form efficiency covers only historical price/volume data, not financial statements or news.
    • B. Incorrect. Allocative efficiency is a distinct concept about capital being directed to its highest-valued uses, not about information reflected in price.
    • C. Incorrect. Strong-form efficiency additionally includes private/insider information, which the stem explicitly excludes.
    • D. Correct. Semi-strong-form efficiency is defined by prices reflecting all publicly available information.

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