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Introduction
While slugging percentage may not place the correct weight on offensive outcomes, it is still a decent representation of a player's power. However, since singles are included in the calculation of slugging, a player who hits singles at a high enough rate could come off as being almost as "powerful" as a player who hits for a lot of extra base hits.
The Mets' David Wright and the Yankees' Curtis Granderson are excellent examples of this difference.
As you can see, Wright and Granderson had identical slugging percentages in 2012. However, Wright's is that high because he had 40 more hits than Granderson. Wright had 41 more singles and 23 more doubles than Granderson, but Granderson had 22 more home runs than Wright. Doing the math for slugging percentage, this comes out essentially a wash, which is why they sport identical slugging percentages. If we were to choose the player with the greater power, however, the majority of us would say Granderson -- he hit 43 home runs versus Wright's 21. This is the problem with slugging percentage -- it doesn't measure raw power very well.
Calculating ISO
Isolated Power, or ISO, is meant to better approximate raw power by removing singles from the equation. Thus, ISO essentially evaluates a hitter's raw power by measuring how frequently he hits for extra bases. ISO can be very simply calculated by subtracting a player's batting average from his slugging percentage. The formula is below.
ISO = SLG - BA
ISO = [((1B * 1) + (2B * 2) + (3B * 3) + (HR * 4)) / AB] - [((1B * 1) + (2B * 1) + (3B * 1) + (HR * 1)) / AB]
ISO = [(2B * 1) + (3B * 2) + (HR * 3)] / AB
Thus, you are only left counting doubles, triples, and home runs.
Conclusion
ISO gives us a player's extra base per at bat rate. If we look back at our Wright-Granderson example, we can see that our hypothesis proved to be correct.
Once we take out the singles, and just look at extra-base hits, we can see that Granderson has significantly more power than Wright does. This doesn't necessarily mean that Granderson is a better player than Wright, because doubles, triples, and home runs don't constitute a player's offensive value, much less his entire value. For that we would look at wOBA and WAR respectively. While ISO isn't a great measure of a hitter's overall value, it does provide us with a good and simple tool to evaluate how powerful a hitter is.