A Change in Media Economics
In my previous post, I talked about the difference between a franchise and a business.
Buffett is of the view that newspaper, television, and magazine properties have begun to resemble businesses more than franchises in their economic behavior.
This is because of the changes in retailing pattern and also an significant increase in other entertainment and advertising choices.
Previously, media properties possessed the three characteristics of a franchise and therefore could both price aggressively and be managed loosely.
Nowadays, consumers looking for information and entertainment have so many choices and the supply is simply much more than demand.
The result is that competition has intensified, markets have fragmented, and the media industry has lost some – though far from all – of its franchise strength.
In light of this phenomenal, let us look at the impact on the value of media properties.
In the past, a newspaper, television or magazine property would forever increase its earnings at 6% or so annually. This would be done without additional capital, as depreciation charges would roughly match capital expenditures and working capital requirements would be minor.
Therefore, reported earnings (before amortization of intangibles) were also freely-distributable earnings. This meant that ownership of a media property is like owning a perpetual annuity set to grow at 6% a year.
Using a discount rate of 10% to determine the present value of that earnings stream, one could then calculate that it was appropriate to pay $25 million for a property with current after-tax earnings of $1 million. (This after-tax multiplier of 25 translates to a multiplier on pre-tax earnings of about 16.)
Back to the present, assume that this $1 million represents “normal earning power” and that earnings will stay around this level instead.
This is true of most businesses, whose income stream grows only if their owners are willing to commit more capital (usually in the form of retained earnings).
Under our revised assumption, $1 million of earnings, discounted by the same 10%, translates to a $10 million valuation. A modest shift in assumptions reduces the property’s valuation to 10 times after-tax earnings (or about 6 1/2 times pre-tax earnings).
This simple example shows that valuations can change dramatically when there is just a minor change in expectations!