This is a way in which the analyst tries to derive fair price for a security based on certain models he uses. And the difference in current market price and his valuation price tells him if the market is overpriced or underpriced.
The models used can be very different depending on the analysts, but some of the entities used to derive the valuation are common.
The models in summary try to project profit/cash flows over next few years and try to predict fair valuation for the security.