Rainbow Tables are commonly confused with another, simpler technique that leverages a compute time-storage tradeoff in password recover: hash tables.
Hash tables are constructed by hashing each word in a password dictionary. The password-hash pairs are stored in a table, sorted by hash value. To use a hash table, simple take the hash and perform a binary search in the table to find the original password, if it's present.
Rainbow Tables are more complex. Constructing a rainbow table requires two things: a hashing function and a reduction function. The hashing function for a given set of Rainbow Tables must match the hashed password you want to recover. The reduction function must transform a hash into something usable as a password. A simple reduction function is to Base64 encode the hash, then truncate it to a certain number of characters.
Rainbow tables are constructed of "chains" of a certain length: 100,000 for example. To construct the chain, pick a random seed value. Then apply the hashing and reduction functions to this seed, and its output, and continue iterating 100,000 times. Only the seed and final value are stored. Repeat this process to create as many chains as desired.
To recover a password using Rainbow Tables, the password hash undergoes the above process for the same length: in this case 100,000 but each link in the chain is retained. Each link in the chain is compared with the final value of each chain. If there is a match, the chain can be reconstructed, keeping both the output of each hashing function and the output of each reduction function. That reconstructed chain will contain the hash of the password in question as well as the password that produced it.
source: Answer by Crunge on security.stackexchange.com
See also: How Rainbow Tables work
See also: https://en.wikipedia.org/wiki/Rainbow_table
Further reading: Password Storage Cheat Sheet