Most Android phones have a geo-magnetic sensor (electronic compass) in them. This is actually a very sensitive device that the Entity Sensor reads then displays with the colored LED display.
The Entity Sensor displays the magnetic field in "micro Tesla"(µT) or "milliGauss"(mG). A technical explanation can be found on WikiPedia
Basically, it's the value of a magnetic field near the phone.
The magnetic field of the earth is between 31µT and 60µT (310 to 600mG), depending on your latitude. That is the baseline reading that the Entity Sensor shows when running in Normal mode.
Any change in the magnetic field will show on the display. An increase in the magnetic field will show more LED's lit, and decrease will show less LED's lit.
You can test this by moving a magnet or other electronic device near your phone.
The display of the LED's is related to the selections in the Settings screen.
If in Normal Mode
(not Baseline Mode), the Sensitivity determines the how many LED's are lit for a particular value.
In Baseline Mode
, when you press the Zero button, that determines your baseline, and all LED's will be off. Any change in the magnetic field will show an increase in the number of LED's lit.