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Backlinks are a type of "vote". By linking out to external websites, Google and other search engine sees this as vouching for those websites. Each website has a certain amount of trust and authority with search engines and when those websites link to other websites, they pass some of that trust and authority.
Website A has a backlink to website B - this will tell search engines that website A thinks that website B deserves better recognition and thus website A is passing along trust and authority to website B, however, website A does not lose any trust or authority.
Backlinks are essential for SEO purposes and in my opinion, it is the most important ranking factor. No website can compete for a competitive term on Google, Yahoo or Bing without backlinks, however, backlinks is not all there is to SEO.
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