Zwift takes the wheel speed broadcast by your speed sensor and the power curve of the trainer you select on the Pairing Screen and converts that to virtual watts. With those watts, the weight entered, height entered, in-game bike used, in-game drafting (Tri and TT bikes get no drafting boost), in-game wheel set, in-game road surface, and in-game virtual elevation changes your in-game speed is determined.
@Paul_Allen should Really need to make this a sticky: