The answer to this question depends on your goals. It is possible to skip the demo step and go straight to recording an album. That's not the answer for everyone, however. Which one is right for you? Consider two possible cases, and see which one fits you best:
Case One - You Want a Record Label Deal:
If your goal is getting signed to a label, then a demo is in order. Let's be clear about something here, however. A demo is never going to get you signed to a major label - or well, almost never. Your demo may end up in the hands of some A&R person of a major label, which may help you get your foot in the door, but you're not going to be able to record a demo, package it up, send off your demo to the label and get "discovered." For one thing, they won't accept your demo for legal reasons (they're worried you're going to accuse them of ripping off your songs in the future). Indie labels are the labels that are, by and large, approachable with demos.
If you want a label deal, then you really need a demo. Your demo can be physical (as in, you have an actual CD to send out) or it can be digital - these things depend on the preferences of the labels to whom you're sending your demo. These demos are how labels get to hear your music and see what you're all about. But why a demo? Why not simply record an album and send it out to labels?
Well, that can work, but it's not the ideal solution because it's expensive. A demo can be recorded for much, much less than a release ready record, and it's a cheap, easy way to go after your goal of getting a record deal. (Some people do believe that your demo should be professionally recorded, but labels understand what demos are and don't expect them to be release ready.) If you have a bit of a following already and think you could sell some albums, the idea of investing in recording before scoring a deal can make more sense, but this can be a catch-22 situation that needs to managed carefully. If you get lots of reviews on your self released album and sell lots of copies, labels think, "why would I want to release that? The promotion opportunities have already been used up, and many of the fans have already bought it." So, you're at square one again, and even if the label wants to work with you, you need a new album. This is a line that can be navigated, but again, this should be left to bands who already have a bit of a buzz about them going. If you're just getting started and you really want label backing, a demo is a better investment. You can find more information about demos here:
Case Two - You Want to Self Release Your Record:
If you have decided to become your own record label, then a demo isn't really what you need. After all, you're the label, you've already decided to sign yourself! And that is an important point really. Many people think they are being revolutionary, shutting out the labels and working the music themselves. In reality, you're not pushing labels out of the business - you're simply becoming one, and if you're going to make this work, you're going to have to do the things they do - you'll just be doing them yourself.
But first things first, and the first thing you need to self promote a record is, obviously, a record. If you're going to be selling an album, you need to worry about recording methods and quality in a way that you don't with demos. You can still record at home on the (relative) cheap if you have the know-how, but you need to turn out a "release quality" record.
Even if you don't have distribution or you plan on using your album to get gigs or get press before you actually give it a formal release date, as long as you're married to the finished product, then you can still skip the demo step. What you really need is a promo. A promo is simply a copy of your album as it is going to be when it is released (as opposed to a demo, on which the songs may be more "works in progress"). Need some more info about self releasing albums? See below:
There is some crossover territory for demos and promos, no matter what your end game is. Both can be used to try to get gigs, find a manager, an agent and a promoter. Learn more:
Of course, all of this begs the question - should you try to get a deal with a label or should you self release your record? There are benefits to being on a label. Even a small label will have the benefit of experience and a network of all of those little things that making selling records easier in place - distribution, relationships with the media, relationships with promoters, and so on. Labels also take some of the financial burden off the band. But - every small label released their first record at some point, and they had to build everything up the same way you would if you were going to release your own record. Making a good run at releasing your own record requires money, patience, dedication, determination and lots of hard work. In exchange for your sweat and tears, you'll be completely in the driver's seat when it comes to your music. Most indie labels don't run as dictatorships, but you still have to give up some measure of control. You have to weigh up the pros and cons and decide which method suits you best.
The middle ground? Well, you may self release an album, do a great job, and then get a deal for your next one (or you may decide you are your own best label after all). Or, you may self release your album, decide this is for the birds, and get a deal for your next one. More often than not, music just comes down to trial and error.