Click images for desktop size: "5 cm Per Second" by Kabegami This is going to be that great definitive Apple TV encoding thing. Except my eyes are failing badly.
Calling doctor's tomorrow. Maybe it will get better.
So forget the even more typos' than usual and trust in the touch typing I had to learn in high school.

I like the Apple TV. In fact I think its great.
My issues are simple: More codec support, accept external HD's, more responsive menu's. Since that seems to be everybody else's issue with the thing doesn't seem a lot of point to belabour it.
For music I've had issues with it choking on some aac and a couple of MP3's that caused it to crash! The MP3's seemed to have malformed ID3 tags (2.5). Why the m4a files choked I'm not sure. I simply get a screen saying that this file is not compatible with Apple TV. In a playlist it just skips the track.
Since I encode all m4a's through the command line and the built into Apple codec and tag them all in iTunes this is peculiar. I use true VBR encoding so that might be part of the issue. It shouldn't be.
For video Apple TV only supports mp4 encoded with the H264 (or the open source X264) codec. Sound tracks have to be either aac or, if you've got a digital output to a digital preamp, AC3 (surround sound).
There are plenty of apps out there designed to automate and simplify encoding your DVD's or avi's into the proper format.
Avi's are problematic. No codec will improve the image or sound of the source. Avi's are lossey files (data is dispensed with to make them smaller). Most of the time avi's transcode okay and a few have been excellent but in general they look pretty poor, kind of smeary and avi blockiness is not removed, nor are halo's (a creepy effect of a bright spot in a dark background).
But my issue was in finding the best way to encode my DVD's.

Click images for desktop size: "Fly With Me" by Anonymous I picked "Spider-Man", the first one. Because I had the SuperBit DVD. SuperBit prides itself on making the best possible DVD's of movies.
I ripped the DVD 3 ways.
I used Handbrake and their Apple TV preset. This encoded the movie at 2500 kbs and allows for embedding both the aac and the surround audio track.
I always use two pass encoding. The first pass examines the movie and creates a log. The second pass examines the movie and the log and then decides where you can get by with more or fewer kbs. It produces the smallest possible file and the best image quality for the bit rate.
To encode "Spider-Man" a 1 hour 52 minute movie it took about 4 hours! It made an mp4 of 2.5 gigabytes. (The DVD is 8 gig) I used An anamorphic setting which produces a 1024 by 526 image. Apple TV handles the Anamorphic image with no problems at all. The original is like 720 by 360.
I then encoded the movie with MpegSteamClip. On this encode I upscaled the image to 720p, the widest resolution the Apple TV can handle. I had to scale back the bitrate to 4.8 mps per second, the Apple TV can handle 5 mps but that would have made a file of over 5 gig. I used multipass encoding. This passed the file 4 times! It took 36 hours!
MpegSteamClip does not allow for any but the aac soundtrack.
I then encoded the movie in Xvid with Handbrake at 1500 kbps with the surround Soundtrack. In multipass this took about 2 hours . . . It produced a file of about 1.5 gig.
Oh, both Handbrake and MpegSteamClip are freeware apps.
To compare the Xvid, DVD I used my Oppo DVD?Xvid player. The Oppo uses its own upscaler to bring each movie up to 720p.
I watched on My Sony lcd.
Now what I saw (even with Bad eyes).
The Xvid was unsurprisingly, the least of them. The picture was acceptable but displayed all the flaws of the codec, smears, occasional blockiness in dark scenes and haloing. None of these would prevent you from enjoying a movie and at least on this encode there were none that were truly horrible.
The Handbrake encode was excellent and it took a cautious eye to detect any difference between it and the DVD! It benefited greatly from having the surround soundtrack. It was bright clear and I never noticed any artifacts. It streamed flawlessly over my class g network, never a stutter.
The MpegSteamClip upscaled image was fantastic! In comparisons it was BETTER than the DVD! The picture was bright and details were crystal clear, revealing wisps of hair and specks of dust in the air. All impeccable. As common sense says it couldn't improve the image quality I put it down to a software upscaler
Click images for desktop size: "Celebrating The Migration Of Swans" taking about 6 hours to enlarge the image was an improvement on the Oppo's excellent but on the fly upscaler.
Where the MpegSteamClip fell apart was in having only the aac soundtrack. Dolby ProLogicII is does not have the dynamic range of AC3 and the flatter, less dynamic range sounds really makes a huge impact in side by side comparisons.
It was disconcerting in that it was noticeably better than the Handbrake encode but it was very difficult to decide if the 36 hours of encoding time is worth the extra detail.
For me I've decided that there are only a few movies out there worth the extra hassle and then only movies that don't have a massive booming soundtrack. Even the Xvid sounded better than the MpegSteamClip. For some movies that would be cool.
And I've probably left out some pertinent detail or fact that you need to know. But I'm feeling creepy enough at the moment to not really care.
Oh, Handbrake is also available for Windows. I note this with chagrin that Handbrake was originally created for BeOS. BeOS was for a brief moment the finest OS ever created.