.dem files just store information for the game to recreate the scene it recorded. It's not an actual video file. eg when you run the demo, TF2 will just render the scene exactly as it happened when you recorded it.
To get it as a movie you'll need to use another program to record the game whilst the demo is running. Xfire can now record ingame, as can Fraps. Both can do this for free, although Fraps will have a watermark on the video and will be restricted to 30 seconds per clip unless you buy the full version.
Fraps is the best program for recording ingame videos. The full version can be obtained quite easily for free.
You will also need some video editing software. the Raw Fraps video files are HUGE! (talking 600megs for 10 seconds huge!)
Uncompressed AVIs f t w!
Are these .dem files stored on the server or can each player record them?
The .dem files will give you much better quality than fraps can ever give you as you are not rendering it in real time and you are dumping a raw avi which is full quality which you can then transcode to any format you wish. All Source games feature the demo recording so it's silly to use anything else.
This was a video I recorded using a .dem file: http://www.youtube.com/watch?v=2w4urPeEJkI