The functionality is actually much more flexible than Stereo Mix. You wouldn't select Stereo Mix as the recording input; if the sound you want to record is coming out of Analog 1/2 (for example) you would click the loopback button and then select Analog 1/2 as the recording input. This overrides the default behaviour of sending the hardware inputs straight to the software inputs, and instead sends what was coming out of the hardware output to the input with the same name (though technically it's sending it to the software input; there's a slight difference in practice). You can also route any other hardware input or software output to the (Analog 1/2) hardware output, making it act as a bus and sending all that audio to the (Analog 1/2) software input.

Might sound a little confusing but you get the hang of it eventually. Basically you can record the output of any source along with any input, all at the same time. So you could capture the sound of your microphone and of a webstream simultaneously.