The SPDIF or TOSLINK interface was never designed for hi-fidelity audio reproduction that is why there is an EBU audio standard for professional audio reproduction.
While the WDTV Live specifications does not quote inter-modulation and harmonic distortion figures, the WDTV Live is audio compatible with other products with a similar functionality and price range.
The WDTV Live is designed and marketed as a video streaming device. There is a considerable audio perception difference between 5.1 movie effect audio and hi-fidelity audio reproduction. 5.1 is designed for an instantaneous audio visual effect because the human sensors are concentrating on the movie experience. Hi-fidelity audio is recorded in stereo to replicate a natural auditorium experience because when listening to music, the human sensors are concentrating purely on audio reproduction.
Hi-fidelity DAC’s are expensive. There is no marketing advantage in using a high quality hi-fidelity DAC in a device that is marketed as a video streaming device. That would be committing marketing suicide especially when the audiophile market is probably 1% of the total audio consumer market.
It also requires a high quality digital to digital converter to produce a high quality digital bit-stream. The digital bit-stream produced by the WDTV Live is not a high quality digital bit-stream and will never reproduce hi-fidelity audio reproduction.
Using an external DAC like the Cambridge Audio will not contribute to any perceivable difference to the hi-fidelity audio experience. I would say that the only perceivable difference will be the pain felt in the hip pocket nerve.
I have an Asus Xonar Essence STX Audio card installed in one of my computers. (Approximately $200) The DAC’s and analogue output used by Asus Audio card are high quality. I feed both the Asus and the WDTV Live analogue and TOSLINK into a Yamaha RX-V457 driving a pair of STAX SR-X Mark 3 electrostatic headphones.
The STAX SR-X Mark 3 electrostatic headphones are the functional equivalent of a pair of $25,000 professional studio monitors. The weakest link in the chain is the Yamaha RX-V457.
The hi-fidelity audio reproduction of the Asus Audio card is far superior to the WDTV Live analogue and TOSLINK outputs. When playing movies, in some movies there was very little perceivable difference between the two as the music soundtrack was secondary.
My conclusion.
I am wary of the golden ears circulating on the Internet who regurgitate technical information without any technical understanding of electronic equipment. Expensive esoteric interconnects, external DAC’s and expensive audiophile amplifiers will never improve the inherent design limitations of the manufacturer’s equipment.
If a person wants to listen to hi-fidelity audio reproduction then purchase a dedicated hi-fidelity system. If a person is only interested in listening to background audio and watching movies then the WDTV Live feeding a general purpose 5.1 amplifier does a more than a reasonable job of reproducing the movie theatre sound experience.