External Content are objects in an e-mail (eg. pictures) that are not directly attached to the e-mail, but that are downloaded from an external source once you open the e-mail. In the e-mail, there is only a link that will instruct your browser to display this external content. Some senders use this method to track if you have opened the particular e-mail along with its external content. The "Deactivate external content in e-mails" setting prevents external content in incoming e-mails from being downloaded automatically when you open them.
If you deactivate external content, some e-mails may not look as they were designed by the sender, because the pictures are missing. This will, however, most likely only affect commercial e-mails, as this method is rarely used in private e-mail conversations. You can activate the content of an individual e-mail by clicking "Show all" above the e-mail.
This setting is not applied to e-mails in your Spam-folder. External content is generally not shown for these e-mails.
If you forward an e-mail whose external content is deactivated, the pictures in the e-mail will be replaced by empty placeholder images.