First Sign My first attempt at carving a house sign for a friend.

I printed the sign from my computer - in this case the typeface is Century Schoolbook, 160pt. I then glued the paper (lightly) to the wood.
I then tried two different methods for tracing the letters onto the wood. At first I tried cutting around the letters, and then once the waste had been removed (as with the 'F' above) I would trace around the letter to produce the outline. This worked, but I found it slightly faster, and more accurate, to simply trace the outline of the letter with a sharp pencil (pressing down firmly), and then once the paper was removed, the outline of the letter would be visible in the wood, and it could be easily traced. Obviously, this second technique would only work if the sign was in soft wood (pine, in this case).
I then used a sharp knife with a thin blade to outline the perimeter of each letter, at first very lightly. As you make additional cuts and go deeper, working from both sides, the cuts will meet at the bottom of the 'V' grove you're cutting, and the wood will start to be removed.
The sign before painting.
Once the lettering has been cut I painted the sign letters, then planed the excess paint off to produce a nice sharp letter profile, and finished with a couple coats of spar varnish.

I actually made this sign twice.

The second image to the left shows what happens when you paint the letters without sealing them with shellac. The paint bleeds, and your sign is ugly. :) This would not necessarily be a problem if you were going to paint the background, but this sign needed to have a clear-coat background, so the sign letters could not bleed. As per usual, the only way to learn something is to do it wrong.