Hello,
Before attempting to install a Live Site to a Local installation, I would recommend you test installing a fresh installation of DotNetNuke to your localhost installation.
Whether you create an application or virtual directory depends on the IIS version, so I would recommend you first of all view the tutorials on how to install a localhost installation to your computer and follow the instructions for the operating system and IIS version you are using.
Even though these are for v4.x, the same process applies to v5