ISO measures the raw power of a hitter by taking only extra-base hits -- and the type of extra-base hit -- into account.
For example, a player who goes 1-for-5 with a double has an ISO of .200.
Extra bases / At-bats OR Slugging percentage - Batting average
Watch: Mark Trumbo delivers a homer and three singles in four at-bats, for an ISO of .750.
Why it's useful
ISO is fantastic for evaluating the raw power within a player, which, of course, is valuable because extra-base hits tend to have a big impact on who wins games. Batting average tells you how often a player records hits, but not how often his hits go for extra bases.
The home run and ISO leaderboards correlate strongly. If a player produces a high ISO, he is likelier to contribute in the homer and extra-base hit departments.