A digital to analog converter takes the zeros and ones from a source like a compact disc or DVD and converts them into analog. DACs can be standalone audiophile components or found inside components like AV receivers, AV preamps and even some of the new USB stereo preamps.
Though it may seem like all digital audio is the same, a high-end DAC can make all digital files sound more lifelike, “smoothing” out the audio.
The most popular DACs these days are USB DACs that take a digital signal from your computer (via USB obviously, but sometimes wirelessly or over Ethernet) and convert the audio to analog for your receiver.
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