The sheep explosian will propel a worm, so a victim can be launched and possibly drowned. The explosian will also detonate oil cans and crates, which may cause enough additional damage to kill even a strong worm.
A sheep attack is especially useful early in a game, when the explosian can be centered among multiple victims. Because the sheep can travel quite a ways, and can drop down over a ledge without hurting itself, it is also a useful weapon for long-range damage, especially when a there is not room for a projectile weapon.
There are dangers to using an exploding sheep. The sheep will turn around if it bumps into an obstacle, and may walk right back towards your worm, or in the very least, away from its intended target. A sheep will walk right off a ledge, and if this is above water, it will drown.
The sheep is also a tool in that it can collect crates that are in its path. If it walks into a crate, then you get the contents.