Media Industry Economics

It is well known that Warren Buffet only invest in businesses that he can understand and he has a superior understanding of business than most. But the lesser known fact is that he freely share his insights in his Berkshire Shareholder’s Letters. We combed through decades of shareholder’s letters to distill Warren Buffett’s business insights into a series of 7 articles.

·         Warren Buffett saw changes in the media industry economics that affects their valuation. “The economic strength of once-mighty media enterprises continues to erode as retailing patterns change and advertising and entertainment choices proliferate.”(1991)

·         He categorizes companies between two spectrums – business and franchise. “An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company's ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise's profitability, but they cannot inflict mortal damage.” (1991)

·         “In contrast, "a business" earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management.”(1991)

·         He foresaw that when 2 or more papers exist in a city, the one that had more circulation would pull ahead and emerged as the standalone winner. “The great majority of families therefore felt the need for a paper every day, but understandably most didn’t wish to pay for two. Advertisers preferred the paper with the most circulation, and readers tended to want the paper with the most ads and news pages. This circularity led to a law of newspaper jungle: Survival of the Fattest. (2006). “

·         Media business was traditionally considered a franchise. Because after competition disappeared, rates for both advertisers and readers would be raised annually.

·         However, upper limit on demand and growing new consumer choices resulted in the media industry losing some of its franchise. “Unfortunately, demand can't expand in response to this new supply: 500 million American eyeballs and a 24-hour day are all that's available. 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.” (1991)

·         Buffett also applied inversion to the question newspaper existence. “Simply put, if cable and satellite broadcasting, as well as the internet, had come along first, newspapers as we know them probably would never have existed.” (2006)

·         In addition to the impact on earnings, the changes also affected valuation.

·         When the media industry was considered a franchise, it had a higher valuation. Buffett gave the following example:

• Growing earnings at 6% p.a., without employment of additional capital
• Reported earnings were also freely distributable earnings
• Discount rate of 10%
• After Tax earnings of $1 million

Based on above, he calculated the appropriate valuation to be $25 million, which translates to P/E of 25x.

·         But, when the media industry was considered as a business, it resulted in a lower valuation. Using the same example, Buffett disregarded the growth of earnings and the resulting valuation was $10 million, which translates to P/E of 10x.

In addition to Warren Buffett insightful comments on the newspaper industry, my other takeaways are:

1. In the examples given, Warren Buffett used Gordon Growth Model on the appropriate earnings to obtain the valuation.
2. The same method is applicable across different industries because he mentioned that dollars are dollars whether they are from steel mills or media companies.
3. Based on the given parameters, the P/E for franchise and business is 25x and 10x respectively.