As the old saying goes, there is no business like show business. And for investors, it can be hard to resist the allure of this industry's stocks. After all, the entertainment industry is responsible for producing and distributing the films and programs that we love to watch. Indeed, investing in Hollywood seems a lot more exciting than buying shares of a bank or a business that makes machine tools. But showbiz stocks are also prone to drama; they reach breathtaking heights when they get things right, but they can also hurtle down in stomach-wrenching plunges. Luckily, there are ways to reduce your risks when looking for an investment. (If you thought investing and fun don't go together, think again. Find out more in Leisure Funds: Where Luxury And Fun Come To Make Money.)

Getting to Know the Industry
Entertainment companies create and deliver to consumers a wide range of content, including movies and programs shown in theaters, on TV and released on DVDs and other digital media. They make their money from the sale of movie box office tickets, the sale and rental of digital DVD products, TV advertising sales, cable, satellite and, ever increasingly, video-on-demand subscription services and internet and mobile downloads.

There are basically three kinds of businesses in the film and TV industry supply chain:

  1. Studios - These are the companies that produce and sell creative content, movies, TV shows and music. Well-known names include News Corp's (Nasdaq:NWSA) Twentieth Century Fox, Walt Disney's (NYSE:DIS) Pixar Studios, Dreamworks Studios and General Electric's (NYSE:GE) Universal Studios.
  2. Distributors - These companies market and distribute movies, TV shows, DVDs and other programs to entertainment retailers. Time Warner's (NYSE:TWX) Warner Brothers, News Corp's Fox/Searchlight, Lionsgate Entertainment (NYSE:LGF) and Viacom (NYSE:VIA) are a few big-name distribution companies.
  3. Retailers - These companies sell and deliver entertainment directly to consumers. They include cinema chains such as Cineplex Entertainment, video retailers and rental outlets such as Best Buy (NYSE:BBY) and Blockbuster (NYSE:BBI); cable and satellite TV providers such as Comcast and DirecTV; TV broadcasters such as CBS (NYSE:CBS) and NBC; and internet-based entertainment providers such as Netflix (Nasdaq:NFLX).

Film and TV entertainment are dominated by a handful of big, diversified players such as Time Warner Inc. (NYSE:TWX) and The Walt Disney Company (NYSE:DIS) that operate in many areas of the entertainment value chain. These giants invest in creative talent and content production, they own content libraries that can be licensed for syndication to other companies and many have their own distribution channels for getting film, TV and DVD content in front of consumers' eyeballs.

Ownership of film studios and television and internet portfolios lets these big companies cross-promote their creative content. A popular TV show, like "Sex in the City", for instance, can spawn a big screen production. Or a blockbuster film such as "Pirates of the Caribbean" can be turned into a video game. Entertainment companies also gain economies of scale and vertical efficiencies by owning both the production content and the distribution channels. (Turn frustrating hours into profit-turning minutes by managing your investing time properly. See Five Quick Research Tips For Busy Investors.)

Industry Dynamics
It's not all fun for entertainment companies. New digital technologies, emerging competitors and shifting markets are testing the industry's traditional business models.

New Technology
For the entertainment industry, new technologies are rapidly transforming the economics of the film and home entertainment industry. Companies are being forced to quickly to feed their content through these new formats. At the same time, companies are investing in pricey new digital production technologies, that will impact the quality of consumers' experience.

New Competition
Not surprisingly, digital platforms are lowering industry barriers to entry, making room for new entertainment businesses. For example, around 2009 and 2010, Apple's (Nasdaq:AAPL) iTunes, Google's (Nasdaq:GOOG) Youtube and the Netflix streaming video service dramatically raised competition in an industry that didn't even exist five years earlier. What's more, the emergence of social networking and user-created content could shift the control of production away from entertainment companies and into the hands of consumers. (Look at the big picture when choosing a company - what you see may really be a stage in its industry's growth. Check out The Stages Of Industry Growth to learn more.)

The illegal reproduction and distribution of copyrighted products such as videos and music has become a serious threat to film and TV producers and their copyrighted products. Physical sales, and to some extent even box office sales, have also been damaged by online piracy in all its forms. When your product can easily be mimicked or copied, illegal sales will cut into any company's profits.

Stock Drivers
So, what drives entertainment share prices?

Content Is King
Arguably, the most important stock driver is exciting, new content that audiences are willing to pay for. Consider the success of brands such as "Pirates of the Caribbean", "Star Wars","The Lord of the Rings", "Harry Potter" and "James Bond". Does the company own copyrights to any popular characters or brand names that can be exploited through the creation of sequels and brand franchises? Read trade publications that cover the entertainment industry to stay on top of new trends. (Learn more in What is an economic moat?)

Staying Ahead in New Technology
New digital technology applications represent a key growth driver. Of course, new technology, such as video downloading and file sharing or services that allow users to avoid advertisements, can threaten established business models. So, it is critical to watch for companies that are able to use new technology to boost revenues and earnings. (Level up your winnings by investing in this fast-paced, highly skilled industry; read Power Up Your Portfolio With Video Game Stocks.)

The entertainment industry has traditionally been a hotbed for consolidation and M&A activity. Size matters in the industry, as bigger companies tend to enjoy economies of scale, with overhead expenses supported by larger revenues. Gains in revenue and cash flow can help to finance new and more costly content production. Size also gives entertainment groups a larger geographic coverage, plus diversification of content, which can serve to hedge against the cost of failures. Vertical integration can cut costs for the company and allow strength in one sector to offset weakness in another.

Regulations, such as those enacted by the Federal Communications Commission, can have a big impact on entertainment companies' growth prospects. Companies can be affected by tighter restrictions on ownership of certain kinds of businesses both nationally and locally. Also, the easing of regulations can prompt M&A activity and create new growth opportunities for companies in the industry.

Key Industry Metrics
Entertainment companies' performance can be judged on a combination of characteristics:

  • Ability to grow audiences
  • Ability to generate sales from audiences
  • Ability to keep costs down and stay profitable
  • Ability to maintain a sound financial structure

Box Office and DVD Sales
Film industry investors keep an eye on ticket sales, the average amount of ticket sales per cinema and the number of cinemas that show the film.

(Average Ticket Sales Per Cinema) x (Number of Cinemas) = Box Office Sales

Opening weekend box office sales are a strong indicator of a film's longer term revenue potential. A poor opening can prompt distributors to lower their advertising spending and cinema chains to reduce the number of showing days. Still, box office sales represent only a small portion of total movie sales, which includes receipts from DVD sales, pay-per-view and video-on-demand, premium movie channels and internet downloads.

TV Ratings
The size of a show's TV audience is a strong indicator of its advertising revenue. The number of rating points for a given TV program tells advertisers what percentage of TV households watch that show. Nielsen ratings are audience measurement systems developed by Nielsen Media Research that determine the audience size and composition of TV programs.

EBITDA, or earnings before interest, taxes, depreciation and amortization, is a popular measure for evaluating the profit performance of companies with large upfront capital expenses. Firms that have invested heavily in a new movie production, for instance, can report big losses in their earnings statements. EBITDA lets investors determine whether the core operating business - without the effects of capital expenditure (CAPEX) and interest payments - is making money. It gives investors a convenient metric for comparing the profitability of companies that have different capital investment patterns. (This measure may have its benefits, but it can also present earnings through rose-colored glasses. For more insight, check out A Clear Look At EBITDA.)

Large capital outlays are a fact of life for most entertainment companies. To finance their CAPEX initiatives, they often rely on debt financing. A little bit of debt can go a long way in making growth plans happen, but problems can occur when debt burdens become unwieldy. The lower the debt-to-equity ratio, the more comfortably the operator can handle its debt obligations. A high debt-to-equity ratio translates into higher risk for shareholders.

Free Cash Flow
At the end of the day, one of the most reliable metrics for judging the performance of entertainment companies - or any other company for that matter - is free cash flow. This measure is calculated as the net cash from operating activities less cash payments for capital expenditures and other additions. Free cash flow gives investors information about how the company generates cash from operations after interest payments and how it funds its debt and other financing activities. (For more see Evaluating A Company's Capital Structure.)

The Bottom Line

The entertainment industry is constantly changing and evolving as it responds to changes in technology and developments that can either make for a more profitable climate or completely destabilize the major players in the sector. The background, metrics and figures that we've gone over in this article will help you as an investor to navigate show business stocks.

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.