Here what Google's Matt Cutts has to say about sub-domains vs folders
My personal preference on subdomains vs. subdirectories is that I usually prefer the convenience of subdirectories for most of my content. A subdomain can be useful to separate out content that is completely different. Google uses subdomains for distinct products such news.google.com or maps.google.com, for example. If you’re a newer webmaster or SEO, I’d recommend using subdirectories until you start to feel pretty confident with the architecture of your site. At that point, you’ll be better equipped to make the right decision for your own site.
Here is what Rand Fishkin from SEOMoz says about sub-domains vs folders
Subdomains SOMETIMES inherit and pass link/trust/quality/ranking metrics between one another
Subfolders ALWAYS inherit and pass link/trust/quality/ranking metrics across the same subdomain
I tend to use subdomains sparingly. I use folders for most things, but I use subdomains in some cases:
- When the software that powers it is hosted by a third party. This is common with blogs, forums, press releases, and company job openings. You can point DNS for a subdomain to a third party and have them handle running the software, but still have the content be part of your site.
- For internationalization. I recommend sub-domains for translated content because it enables you to set up a server in the country that you are targeting. You can do that transparently to your users at any point. It is just a DNS change.
- When content needs to be hosted by a content delivery network (CDN). This is very common for images of a site.
- When you don't want the same cookies to be sent. Cases such as different logins for different sections of your site, or when your www cookies are large and you create a different subdomain that won't get them for performance reasons.
- When you may not want to fully vouch for the content. For example you give each of your users a subdomain and let them have free reign with the content that they host there.