You do not use preferences to get iTunes to recognize the location of media. It is only used to tell iTunes that is where you desire it to store any media added to the library in the future. As it says "Media folder location", but a library is more than a media folder just as a city library is more than a bunch of boxes of books on a street corner.
The best way to get iTunes to put the library on an external drive is to first ensure (as norm123 suggests) you have it all together in one package inside your iTunes folder. You then copy the folder with all the media and all the support files to the external drive. Start iTunes while holding down the option/alt key so it asks you which library to use, and select the iTunes folder you just copied to the external drive.
If you do not have it all together in one place, perhaps because you do not have enough room on the internal drive, then we will need detailed listings of which library components you have where and we will have to re-assemble your library from the bits and pieces. This isn't a simple matter, particularly when using an external drive. iTunes will not keep track of things your move, you have to let iTunes itself do the moving.
What are the iTunes library files? - http://support.apple.com/kb/HT1660
More on iTunes library files and what they do - http://en.wikipedia.org/wiki/ITunes#Media_management
What are all those iTunes files? - http://www.macworld.com/article/139974/2009/04/itunes_files.html
Where are my iTunes files located? - http://support.apple.com/kb/ht1391
iTunes 9 [and later]: Understanding iTunes Media Organization - http://support.apple.com/kb/ht3847 - plus supplemental information about organizing to new structure https://discussions.apple.com/thread/6477809?answerId=26404702022#26404702022
Image of folder structure and explanation of different iTunes versions (turingtest2 post) - https://discussions.apple.com/docs/DOC-7392 and making an iTunes library portable.
