Airtunes is a digital signal. iTunes converts everything to Apple Lossless compressed format for wireless streaming to Airport Express (so AE will only work with iTunes). AE decodes the signal and has a built in DAC, about the same quality as the iPod has, to output an analog signal. But it can also output a digital PCM signal, as Waip describes, through the same dual purpose mini-jack, so you can feed the signal to another DAC.
Pjohnston, the Airport Express can be configured a couple of ways. If you're only concerned about getting music on your computer wirelessly through iTunes to your stereo, then no, you don't a preexisting wi-fi connection. Your wi-fi enabled computer and the AE connected to your stereo are all you need to set up your music-only network. As has been mentioned in other threads, setting up AE is not straightforward but also not terribly difficult.