I guess I'll chime in on how a DAC works:
It converts a digital signal into an analog signal, basically. The digital signal is generally received through any digital interface like USB. Depending on the specs of the DAC, it will be able to support a variation of samplerates (44.1KHz, 48KHz, 96KHz, etc.) and bitrates (16bit, 24bit, 32bit). The higher the bitrate and samplerate, the better quality the signal there is. I read somewhere that listening to 24/192 is actually bad for your ears, though... Also, different DACs have different SNR (sound to noise ratio). The higher the SNR is (measured in dB), the more resolution the DAC will have because you will be able to achieve a higher volume without hearing any hiss (noise from the source equipment). For example, here is a graph of some DACs and their respective SNRs (Courtesy of Audio-gd):
I'm sure some of you have heard of Wolfson DACs, and how they're so great, and this is the main reason why (the Wolfsons are the WMxxxx). They're able to achieve a high SNR while supporting a wide array of bitrate and samplerate formats. I'm also sure some of you have heard some DACs or DACs/Amps using dual Wolfson DACs, and that's because some of them are only able to convert one channel, like the WM8741. So, you'll need two of them in order to have both channels converted into an analog source for the amplifier to amplify. You want the highest SNR possible from a DAC so that the noise generated from the DAC + the noise generated from the Amp will be as little as possible.
About 90% of the world uses CD quality audio (44.1/16), so the crazy formats that some of these chips support will be useless, unless you that 10% that uses 192/24 (more like 2%). You may think upsampling them will make them sound better, but that's like converting an MP3 128kbps into Flac. It's pointless, and it may even lower the audio quality in the process. So, you're better off not touching anything in that area.
Well, that's about all I know on DACs.
They don't replace the DAC, they just reroute the signals right after the traces leave the DAC, thus completely bypassing the amp. The 4th gen rewires the headphone out as a line out, and the 5/5.5 gen rewires the dock as a line out, while retaining the functions of the dock.