It resolves the domain to its IP address via DNS, then looks up that address against a public IP geolocation database to identify the hosting provider or network operator (ASN), the ISP, and an approximate city-level location. If you paste an IP address directly, the DNS step is skipped entirely.
Why this is useful for SEO work
Knowing what a site actually runs on helps explain things a page-level audit can't: whether a competitor is on a premium CDN versus shared hosting, whether a site migrated providers around the time its rankings moved, or whether several domains you're comparing are secretly hosted on the same infrastructure.