A PESTEL analysis is a strategic framework commonly used to evaluate the business environment in which a firm operates. Traditionally, the framework was referred to as a PEST analysis, which was an acronym for Political, Economic, Social, and Technological; in more recent history, the framework was extended to include Environmental and Legal factors as well.
The framework is used by management teams and boards in their strategic planning processes and enterprise risk management planning. PESTEL analysis is also a very popular tool among management consultants to help their clients develop innovative product and market initiatives, as well as within the financial analyst community, where factors may influence model assumptions and financing decisions.
Broadly speaking, political factors are those driven by government actions and policies. They include, but are not limited to, considerations like:
Other fiscal policy initiatives
Free trade disputes
Antitrust and other anti-competition issues
It’s worth noting that even the overhang of potential trade disputes or antitrust issues can present material risks and opportunities for management teams. Divergent stances on key platform issues between parties on the left and the right can also make run-ups to elections particularly challenging for a firm’s management team, as the range of possible outcomes can vary considerably depending on election results.
Political factor example: A multinational company closes several facilities in a higher tax jurisdiction in order to relocate operations somewhere with lower tax rates and/or greater state funding and grant opportunities.
Economic factors relate to the broader economy and tend to be expressly financial in nature. They include:
Many analysts in the financial services sector tend to overweight economic factors in their analysis since they’re more easily quantified and modeled than some of the other factors in this framework (which are somewhat qualitative in nature).
Economic factor example: Based on where we are in the economic cycle and what Treasury yields are doing, an equity research analyst may adjust the discount rate in their model assumptions; it can have a material impact on the valuations of the companies they cover.
Social factors tend to be more difficult to quantify than economic ones. They refer to shifts or evolutions in the ways that stakeholders approach life and leisure, which in turn can impact commercial activity. Examples of social factors include:
Attitudes around working conditions
Social factors may seem like a small consideration, relative to more tangible things like interest rates or corporate taxation. Still, they can have a shockingly outsized impact on entire industries as we know them. Consider how trends towards healthier and more active lifestyles have ushered in the evolution of connected fitness technologies, as well as many changes to the nature of food products we consume and how these food products are packaged and marketed.
Social factor example: Post-pandemic, management at a technology firm has had to seriously reevaluate hiring, onboarding, and training practices after an overwhelming number of employees indicated a preference for a hybrid, work-from-home (WFH) model.
In today’s business landscape, technology is everywhere — and it’s changing rapidly. Management teams and analysts alike must understand how technological factors may impact an organization or an industry. They include, but are not limited to:
How research and development (R&D) may impact both costs and competitive advantage
Technology infrastructure (like 5G, IoT, etc.)
The speed and scale of technological disruption in the present business environment are unprecedented, and it has had a devastating impact on many traditional businesses and sectors — think Uber upending the transportation industry or the advent of eCommerce revolutionizing retail trade as we know it.
Technological factor example: A management team must weigh the practical and the financial implications of transitioning from on-site physical servers to a cloud-based data storage solution.
Environmental factors emerged as a sensible addition to the original PEST framework as the business community began to recognize that changes to our physical environment can present material risks and opportunities for organizations. Examples of environmental considerations are:
Climate change impacts, including physical and transition risks
Increased incidences of extreme weather events
Stewardship of natural resources (like fresh water)
Environmental factor example: Management at a publicly traded firm must reevaluate internal record keeping and reporting tools in order to track greenhouse gas emissions after the stock exchange announced mandatory climate and ESG disclosure for all listed companies.
Legal factors are those that emerge from changes to the regulatory environment, which may affect the broader economy, certain industries, or even individual businesses within a specific sector. They include, but are not limited to:
Licenses and permits required to operate
Employment and consumer protection laws
Protection of IP (intellectual property)
Regulation can serve as a headwind or a tailwind for operators. An example headwind might be increased capital requirements for financial institutions; an example tailwind is if regulation is so heavy in a particular industry (let’s say food production) that it may serve as a protective moat for established operators, creating an additional barrier preventing potential new entrants.
Legal factor example: A rating agency is assessing the creditworthiness of a technology firm that has considerable growth prospects in emerging markets. The analyst must weigh this growth trajectory against the inherent risk of IP theft in some jurisdictions where legal infrastructure is weak. IP theft can severely undermine a firm’s competitive advantage.
How is PESTEL Used in Financial Analysis?
Combined, the six PESTEL factors can have a profound impact on risks and opportunities for firms. It’s imperative that the analyst community recognize these and attempt to quantify them in their financial models and risk assessment tools.
Some examples include:
Financial analysts may adjust model assumptions such as revenue growth rates and gross margins based on inflation expectations.
A business that has done a poor job managing its carbon footprint may be subject to future fines or carbon tax levies, so analysts may wish to project a cash reserve accordingly.
A changing macroeconomic environment may require analysts at credit rating agencies to build in a higher interest rate buffer for sensitivity analysis when calculating a firm’s debt service coverage ratio.
Massive levels of automation in a particular industry are expected to reduce labor costs by X% — which would materially change free cash flow estimates in a financial model.