About 2 years ago I decided to go all digital and rip my entire CD collection (500 CDs and counting) to a dedicated file server. At the time I used and continue to use EAC to rip and LAME to compress to 224 VBR MP3s.
I tossed and turned on whether to compress at all, choose a more obscure loss less compression such as Ogg or go with a propriety compression such as WMA or later AAC. MP3 won out for a numer of reasons, and I still stand by them:
1. Across platform and multi device compatibility.
2. Additional associated data possibilities, such as comments reviews and album art.
3. There is significant blind test data that shows that a compressed MP3 file at 224 VBR is indistinguishable from the original WAV file at 16 bit (native format for CDs),
4. there is no way I am given Bill Gates and to a lesser degree Steve Jobs any say as to when, where and how I can play my music files, $!&% fair use and embrace open format.
5. MP3 may not be the best option out there but it is the MOST versatile.
To answer you question about an external DAC being required for hard drive audio, the answer is YES YES YES. There is a significant difference in sound quality with an external DAC, even a cheap one like and old soundstream / krell DAC1. With a good / great DAC I personally can not tell the difference between a CD transport and my hard drive, Add to this the incredible flexibility of spooling music files to any room in my houses over my home network, and immediate access to over 5000 files and I will never be going back.
As an aside anyone who claims that they can hear the difference between a AAC file encoded at 224 and an MP3 encoded at the same bit rate with a playback on an iPOD (ie relying on the ipod internal DAC and less than perfect headphones, compounded by ambient noise, is clearly delusional.
If I had access to a $100,000 rig in a perfect sound room, then perhaps I would have chosen differently, but given my current mid fi system, I think I have found a great balance. If you are interested in external DARs to spool mosaic files to a DAC then check out my thread in this forum on an Audiotron. With web enable wifi access you can also control the entire system from a wireless PDA.
And finally, I also own a new version 30gig Ipod and I love it, not in a carnel sort of way, butin a wow this is great piece of industrial design. I also think that it has by far the best user interface for an MP3 player out here. Try scrolling through 2000 titles with a forward and back button