I picked up some foam boards from Michael’s or Hobby Lobby. They are 1 inch thick and measure 12″ x 10″. You can buy one for $4.99 or you can buy a pack of four for $10.99 (Hobby Lobby – Styrofoam Blocks) which is obviously a better deal if you are going to be doing more than one letter. I use one entire board for each letter, although you could make multiple smaller letters from one board (I haven’t tried this). Draw out the letter onto the foam board using a sharpie or pen (I use the edge of the board for the edges of the letter since this keeps all the letters the same dimensions). You can then use a serrated knife or any type of foam cutter to cut out the letters. Be careful not to press to hard as the foam might snap (if it does simply hot glue it back together and continue carefully). Once you have the letters cut out you can cover them with fabric.
I also picked up the fabric from Hobby Lobby while I was there. Just get enough to cover the number of foam squares you will be using, plus a little extra to be safe. The fabric is usually pretty cheap. Feel free to use any scrap fabric you may have as long as it is a little longer than 12″ since you have to slightly fold it over the edges. Cut the fabric into 13″ x 11″ rectangles. You then simply use hot glue to glue the fabric around your cut out letters.
If you wish to hang the letters, or would like to add a little more pizzaz besides just the fabric, I would also pick up some ribbon. Get an opaque type of ribbon that is smaller than the width of the styrofoam board (I usually get ribbon that is 3/4 of an inch thick although you could go up to 1″ thick). Using the glue gun again, secure the ribbon around the outside of the letters (on the surface perpendicular to the wall – see pictures). You can also use this same ribbon to create a hanger for the letters. You can glue this ribbon to the back of the letters.