Setting up the local media files and connecting them to your media server
As I said at the outset, streaming media from the Internet raises issues around tiered broadband pricing, plus the selection of Internet media is limited. And you no doubt have hundreds of CDs and dozens of DVDs you've purchased or created (such as for home movies).
It makes a lot of sense to convert those media into digital files, stored in iTunes on your computer, ready for playback via an Apple TV whenever you want. But this part of an iTunes-based media center can be tricky to set up.
By default, iTunes is your computer's media server, storing any media files on your computer. That means everyone's computer can be a source of video and audio to an Apple TV via Home Sharing. But it also means that your family's media library can be highly fragmented across those computers.
What a media center should have. I recommend you set up a common media server that contains the videos and music for the whole family. People can also have their local music and videos on their own computers. (Do you really want your kids' music or cartoons in your library?) That way, you get the best of centralized media and the best of decentralized media.
That common media server is a computer running iTunes. It should be a power-efficient one like an iMac, as it will be on pretty much all the time, even if in sleep mode when not in use. This media center need not be a separate computer; you could use one person's computer as the media server for everyone. A recent PC or Mac has more than enough horsepower to be a media server and a work computer at the same time.
Where to store media files. One tricky area is where to store your media files. When you throw videos into the mix, you can easily fill a 1TB hard disk. An external disk connected via a fast bus (USB 3.0 or FireWire 800) is the way to go. I also recommend you have a separate backup drive for that media content, so you don't lose all those files if the media disk craps out; OS X has Time Machine backup included, whereas Window users will need a backup utility.
Then you need to tell iTunes to use that external drive instead of your computer's boot drive to get the media content. In the iTunes Preferences dialog box, go to the Advanced pane and click Change in the iTunes Media Folder section, then specify the external hard disk and folder.
Here's where it gets tricky: By default, iTunes copies media files to the media folder specified in the Advanced pane. If you're (re)building a media server from scratch, you want keep it that way, so all your imports are stored on that external disk. In that case, be sure that Copy Files to iTunes Media Folder is checked. Then import all your media files, as I explain shortly, so they are copied to that folder.
On the other hand, you may not want to store all your media on that external disk. For example, if you use a laptop as your media center PC, you may want to keep some videos for watching when on the road. In that case, go to the iTunes Preferences dialog box's Advanced pane, uncheck the Copy Files to iTunes Media Folder option, close the dialog box, and import the media into the iTunes Library. Any media imported while Copy Files to iTunes Media Folder is unchecked is not moved to your master media library folder. Of course, if your laptop were your media center, anyone else in the house would be media-deprived while you were out of town.