Traditionally, Linux was installed by compiling and setting up everything by hand. This was a rather black art and was only performed by those with sufficient dedication and patience.
Modern Linux distros evolved out of a need for a more automated install process. However, there were many benefits to installing from source:
Hardware can be inhomogenious (especially Intel-based systems). You can enable hardware enhancements that may be disabled in a generic install. (Though this isn't necessarily as important with many non-Intel systems such as PowerPC's)
You have control over the decisions made when compiling your software.
You can choose which versions of applications to use, and may even be able to run multiple versions of the same software simultaneously.