The sheep barn does not appear automatically on your farm from the beginning like the cow barn and the chicken coop do. You have to have Ken build you the sheep barn. Ken requires you to have 800 pieces of wood and 70000G before he'll build it for you. The sheep barn takes him about 8 days to finish.
Ken also builds a pasture area behind the sheep barn. In order to buy sheep from Chet, you need to have a lot of grass planted back behind the sheep barn. Most of the pasture area needs to be covered with grass. Approximatly 16 bags of grass seed should cover all of the ground with grass.
After the grass starts to grow, you can buy sheep from Chet. He sells medium size sheep for 5000G a piece. Chet will also give you the Horn when you buy your first sheep, which will allow you to call the sheep out into the pasture area. You should also buy the Shampoo, which acts just like the Brush on the cows. Using the Brush on sheep doesn't have any happiness affect, so you need to use the Shampoo instead. The other item you need are the Clippers, which you'll use to harvest the wool off of your sheep. Bill sells the Clippers at the beginning of the game for 2000G. Once you have the sheep barn built, you can also purchase Sheep Feed (1000G), Sheep Medicine (1500G), and Sheep Seed (4500G) from Chet.
Your first sheep will be medium size, and they take 22 days to grow into adult sheep. After that you can harvest the wool that grows on the sheep. To do that you need to have the Clippers equiped as your active tool. Then just walk up to a wooly sheep and press the A BUTTON. A sheering animation will play and then you can take the wool and put it in the shipping bin that's in the lower left corner of the barn. At first you'll get small pieces of wool, which sell for 200G a piece. Eventually when your sheep have a higher happiness rating you'll be able to get large pieces of wool, which sell for 250G a piece. You can check your sheep happiness by going into your system notebook (Press SELECT twice) and then picking the sheep option. The sheep information is layed out just like the cow one. You can find out your sheep's current size, whether it's grumpy or happy, it's happiness rating, and how long is left before a pregnant sheep gives birth.
Pregnant sheep will be next to the feeding bin that's located in the upper right corner of the barn, just like the cow one. It takes 30 days for a sheep to give birth. Once it's born, a Lamb will take 15 days to become a medium sized sheep. To inpregnat a sheep, buy the Sheep Seed from Chet and equip it as an active tool. Then just walk up to which ever sheep you want to have a baby and press the A BUTTON. If you leave and return to the barn, the pregnant sheep should be in the pen that's in the upper right corner. If it's not, then you missed with the potion and you'll have to buy another one.
Sheep will regrow their wool every 9 days. They don't make as much of a profit as cows do, but you can still get some pretty neat things from them. If you are good friend with Bill he may make you the Yarn and the Knitter machines. They both cost 30000G a piece (just like the Cheese and Butter Makers) and they sit in the upper left corner of the barn. To use them you just need to sheer a sheep and toss the wool (both small and large will work the same) into one of the machines. You'll then get the finish product and you can toss it into the shipping bin. Yarn and Knitwear both sell for 300G a piece.