H264 is a codec, same as divx/xvid, lagarith, utvideo, huffyuv, mjpeg, picvideo, etc... they compress video as opposed to "non-compressed" raw. It's not a process or a means to make your video look better (in most cases, bad compression will make your video look worse). All it does is compress the video, that's it. This also has nothing to do with how an editing program "stores" video files.
When you're editing, we recommend you use a lossless codec like huffyuv, utvideo, or lagarith. These are generally a lot faster to edit with but take up a lot more space on your hard drive (hard drives are cheap though). They also aren't losing the original quality due to the compression processes as opposed to lossy codecs (h264, xvid, divx, mjpeg, picvideo).
Anyway, read the guide i posts, this is all explained a lot more in detail.