PESTLE and the innovation matrix

What does PESTLE add to Five Forces?

Five Forces explain how profitable an industry is from the competition inside it. PESTLE analysis looks outside, at political, economic, social, technological, legal and environmental influences, and is more concerned with the industry’s growth rate and how market share shifts between firms that adapt well and firms that do not.

The output is a set of themes, positive or negative, that an analyst can carry into the valuation, for an industry or for particular companies in it. A sharp, lasting rise in energy prices, for example, hurts energy-hungry industries such as glass and fertilizer while speeding up demand for insulation and heat pumps. One outside event, opposite effects on growth.

PESTLE analysisthemes for the valuation, positive or negative

• Political Memorize policy, regulation, geopolitics, government buying, state ownership, taxes and subsidies
• Economic Memorize cycle, structural growth, development stage, business process outsourcing, exchange rates
• Social Memorize demographics, tastes, lifestyles, rising incomes
• Technological Memorize productivity; the innovation matrix
• Legal Memorize courts and laws: costs, practices, bans
• Environmental Memorize energy transition; heavy energy users

Political influences

Political influences are government policy and action. Indirect ones are trade, fiscal and monetary policy, regulation and geopolitics. Direct ones are the government buying or selling the industry’s goods and services.

In some industries, often commodity producers and utilities, the government owns or controls the main firms, so politics matters even more.

New taxes, restrictions or regulations, or just the threat of them, can cut revenue and profits. Subsidies, or the government paying part of a product’s cost, can lift an industry or steer customers from one product to another: a tax credit on home heat pumps shifts buyers away from gas boilers.

Health care shows the direct side. Governments license hospitals and doctors and decide which medicines public programs pay for. What is reimbursed, and for which patients, can decide a drug’s revenue.

Economic influences

Economic influences are the business cycle in the short run, and growth and structural change in the long run. An industry forecast should be consistent with the expected growth and inflation of the economy, adjusted for whether the industry is defensive, cyclical or in an above-trend growth phase, as Lesson 3 describes.

Developing economies attract capital, which raises productivity and lets them grow faster than developed ones. Goods producers move mass production to lower-wage countries, and service firms use business process outsourcing (BPO) : moving customer service and back-office work to lower-cost locations.

Exchange-rate effects reach an industry through its costs and its sales. When the home currency depreciates, imported inputs such as raw materials and energy cost more, so margins shrink unless firms have the pricing power to pass the cost on. The same depreciation makes the industry’s exports cheaper for foreign buyers.

Social influences

Social influences are culture, consumer trends, demographics, lifestyles and attitudes.

As income per person rises in a developing economy, spending shifts from cheap necessities toward branded, better-quality goods, durables such as appliances, furniture and cars, and leisure, entertainment and travel. In developed markets, firms compete on quality, brand and features: convenience, flexibility, health, and openness about where products come from, local sourcing and fair working conditions.

Firms that adapt to local tastes can combine steady growth at home with faster growth abroad. A coffee chain that sells green-tea drinks in East Asia and spiced drinks in India is doing exactly that.

Technological influences and the innovation matrix

Memorize

Technological influences mean that technology creates products, transforms business models, improves existing products or makes them obsolete. It is a key driver of total factor productivity , so analysts ask when and how it will change competition in an industry.

A domain is the area where an innovation is applied: a product, a business process or a market segment. The problem an innovation addresses may be distinct (clearly defined, a need people already recognize) or indistinct (not yet clearly defined). The domain may also be distinct (one known product, process or market) or indistinct (open, not tied to one). The innovation matrix sorts technological change on those two questions.

	Domain indistinct	Domain distinct
Problem distinct	Breakthrough innovation	Sustaining innovation
Problem indistinct	Basic research	Disruptive innovation

• Basic research (both indistinct): understanding fundamental scientific principles, usually with no immediate commercial use. Governments and universities are often the largest funders, and technology, manufacturing and drug companies also pay for or do it. Turning it into revenue takes years and is far from certain. Our example: a university team studying how a soil bacterium turns air into fertilizer, with no product planned.
• Breakthrough innovation : a new product, service or business model, or a fundamental change to existing businesses, with big effects across industries. It usually follows years of basic research. Our example: satellite positioning, which reshaped shipping, farming, mapping and ride-hailing.
• Sustaining innovation (both distinct): better performance or extra features without changing how the product fundamentally works, usually led by incumbents for their existing or nearby customers. Our example: each year’s dishwasher using less water.
• Disruptive innovation : creates a new market or redefines an existing one with a different value proposition that satisfied customers may ignore at first. Our example: phone apps that let small traders accept card payments without a terminal.

Sustaining and disruptive innovations hit an industry’s results soonest. Entrants have little to lose from a disruptive innovation because they have no profitable business to protect. Incumbents can invest in it themselves, speeding the decline of their own business to keep or win share, or adopt it slowly and lose share while still earning good profits for a while.

Technological changesorted by problem and domain

• Basic research Memorize problem indistinct, domain indistinct
• Breakthrough innovation Memorize problem distinct, domain indistinct
• Sustaining innovation Memorize problem distinct, domain distinct
• Disruptive innovation Memorize problem indistinct, domain distinct

Exam tip Hook for the matrix: start bottom-left and go clockwise: Basic research, Breakthrough, Sustaining, Disruptive.

Legal influences

Legal influences are laws and regulations from courts and policymakers that impose constraints or costs, change how an industry does business, or open or close whole markets by banning or allowing activities.

Firms respond by moving or outsourcing work to friendlier jurisdictions, or by aiming their growth where the rules are lighter, and industries adapt their products to the rules over time. When a country bans single-use plastic bags, for example, bag makers shift to paper and reusable bags.

Legal and technological influences meet when an innovation has no legal framework yet. Delivery drones are a case: the technology works, but where they may fly depends on rules still being written.

Environmental influences

Environmental influences are often tied to political, social and legal influences; energy producers and heavy energy users feel them most.

The energy transition is the structural shift, mandated by many governments, to cut greenhouse gas emissions from energy use. Governments move at different speeds with different mixes of taxes and subsidies, so producers in the same industry adapt differently.

For heavy energy users such as airlines, shipping, carmakers and other manufacturers, changes in rules, taxes or customer preferences mean adapting operations or losing share to lower-emission competitors.

Five Forces said how much profit an industry keeps. PESTLE says how fast it can grow and who will gain share. Learning Module 10 turns to the company itself.