Dynos come in multiple flavors. The "water brake" dyno that Jerry has is a style that uses an impeller to absorb the power as water is added into the case. The reaction force (resisting the case of the dyno turning) and the engine RPM are used to calculate torque and horsepower. The same concept is used for a "friction dyno" (aka
Prony Brake), basically a brake shoe that's applied to a flywheel, and the force developed measured at the end of an arm. Force x distance = torque. Add in rotational speed, and you have horsepower. Chassis dynos use a big drum that's driven by the wheels, but the concept is the same - measure torque and calculate horsepower. Back in college in the late 60's we ran lab tests on various engines using a couple types of dynos, one being a water brake type.