While iPods don't have a digital output naturally, there are mods which can get you a digital out. There are probably even 'accessories' which could do it now, although I don't know any off the top of my head.
The iPod DAC seems to be considered very good for the money, and people seem happy with it, although of course you *could* get sound improvements by using another separate DAC in conjunction with an iPod made to have a digital output, if you are prepared to pay more for that privilege.
Although I tend not to be a fan of the iPod simply because it is way over-hyped for what it is, and Apple are happy to charge more because of that hype. For the same price as an iPod you could get much more storage, and optical output, if you look around at other brands.
What I'm wondering about is: Portable DACs, do they even exist? I mean, without having it bundled with a portable amp. I personally already have a portable amp, and a separate DAC which I use at the moment with my PC, but while the DAC is small and might be portable, it needs AC power!
I have another which runs off USB which would be handy if I was using a laptop as my portable rig... But not very compact! I have an EeePC and while it's small; It isn't small enough to go in my pocket, so I need a small back pack whenever I want my music with me.
Is there a DAC which is battery powered, inputs optical, and small enough to rubber-band together with my portable amp and player with optical output, and put in my pocket?
And sound good of course, ha ha.
I don't think there could be otherwise I'm sure I would have heard of it... Perhaps a DIY project?