The word Sheol simply means "pit". It functions as a euphemism for the grave, though in some biblical texts appears to be a kind of underworld, populated by the wicked and the powerful. References to it in the Torah are sufficiently oblique as to lend themselves to either of those readings.
As to whether or not there is reward and punishment after death, your friend's claim is a valid one but that doesn't mean it is necessarily correct. There are no references to post-mortem judgment in the Torah, to the extent that the rabbis (who later considered it necessary to believe in such a thing) went to very creative lengths to read such references into the text.
Outside of the Torah, but still in Tanach, there are indications either way. Qohelet 3:18-21 appears to explicitly assert that the fate of humans and animals is alike in being nothing, while Psalm 115:17 says that the dead don't praise God. On the other hand, Isaiah 66:24 appears to imply that the wicked will suffer perpetually in death, and Daniel 12:2 explicitly says that people will experience a bodily resurrection, the righteous for eternal glory and the wicked for everlasting shame.
A major point of conflict between the Pharisees and the Sadducees was the latter's belief in there being no reward and punishment after death, while the former stressed it as an integral article of faith. That is mentioned by Josephus (Wars of the Jews, 2.8.14), who says that the Pharisees believe "that all souls are incorruptible; but that the souls of good men are only removed into other bodies, - but that the souls of bad man are subject to eternal punishment", and that the Sadducees "take away the belief of the immortal duration of the soul, and the punishments and rewards in Hades" (trans. William Whiston).
This conflict, incidentally, is also recorded in the rabbinic literature. The Mishna in Berakhot 9:5, for example, records that people used to conclude their berakhot in the Temple with the insertion of the words, מן העולם - "from the world". When the number of sectarians increased, who claimed that there was no world other than this one, the sages altered the blessing to מן העולם ועד העולם - "from this world to that world", loosely translated.
Perhaps the most famous example of a passage that the rabbis recontextualised to refer to the world to come is Isaiah 60:21. There it is declared that "your people is entirely righteous; they will forever inherit the land" (עמך כלם צדיקים לעולם יירשו ארץ). Isaiah is of course speaking of the land of Israel, the eternal inheritance of which is the focus of the book's final twenty-seven chapters. Since it doesn't take long for people to feel that their restoration in the land of Israel was an incomplete one (being first subject to the authority of an empire, and subsequently possessing a monarchy, but one comprised of priests), the passage was reinterpreted.
The most well-known instance of its reinterpretation is in the New Testament: Matthew 5:3-5. In verse 3, Jesus blesses "the poor in spirit, for theirs is the kingdom of heaven". In verse 5, Jesus blesses "the meek, for they will inherit the earth". Samuel Tobias Lachs, in his A Rabbinic Commentary on the New Testament (New Jersey: Ktav, 1987), suggests that these two verses are both the same, and that the variation between them originated from a marginal gloss. "Poor in spirit" = עני, while "meek" = ענו. What is more, inheriting the earth is inheriting the kingdom of heaven, based on an exegesis of Isaiah 60.
For a Jewish parallel, and one more pertinent to your question, there is the famous mishna in Sanhedrin 10:1. There it says that all Jews receive an inheritance in the world to come (כל ישראל יש להם חלק לעולם הבא), and the proof-text is Isaiah 60:21. What is more, of the people who void their inheritance, one such category is those who deny the resurrection of the dead, which was an integral component of the rabbinic belief in reward and punishment. Another such category is arguably those who deny reward and punishment altogether, in the manner of Epicurus (apikorus in Hebrew), who asserted that the gods have no interest in the activities of men.
One way or another, while your friend may be correct about beliefs held by certain Israelites (and is certainly correct that there have always been Jews who denied reward and punishment, the world to come and resurrection), neither attitude can be substantiated by anything explicit within the Torah, and both require some degree of interpretation. As such, you can feel to translate Sheol as either "grave" or "underworld", depending on personal preference and immediate context.