from a MacWorld editor's note by Jason Snell:

iTunes does the heavy lifting. When iTunes plays back standard audio content (AAC, MP3, audiobooks, music streams), it decompresses those file formats and creates what's essentially a raw, uncompressed audio stream. That stream is compressed on the fly using Apple's Lossless Compression, encrypted, and sent to the AirPort Express. AirPort Express decrypts the stream, decodes it, and outputs it in either analog format (if you plug in a standard analog mini jack) or as a digital PCM stream (if you plug in a mini-sized optical cable, which you can get from most major cable suppliers or straight from Apple for $39).

If iTunes is playing back a digital multichannel file format like AC3 (Dolby Digital) or DTS, those bitstreams are wrapped in Apple's compression and encryption, and then decoded at the other end. In those cases, AirPort Express would end up streaming the raw AC3 or DTS stream via an optical cable to your home theater receiver for decoding.