Shares of DigitalOcean (DOCN 3.30%) dropped 14.9% in October, according to data provided by S&P Global Market Intelligence. However, the stock has already made back all of this lost ground in early November, after exciting the market with its latest quarterly financial results.
In October, the market was partly reacting to some negative commentary from analysts regarding DigitalOcean stock. Multiple analysts reevaluated DigitalOcean as an investment and consequently lowered their price targets.
For example, in mid-October, Barclays analyst Raimo Lenschow lowered his price target for DigitalOcean stock from $42 per share to $30 per share, according to The Fly -- a substantial reduction of 28.6%, which shook investor confidence.
However, DigitalOcean was able to restore a degree of confidence to the market after it reported financial results for the third quarter of 2023 on Nov. 2.
What was so good with DigitalOcean's quarter?
Cloud-based enterprise software companies are performing poorly in 2023. Businesses are looking to save money wherever possible. And in many cases, they're able to spend less with existing cloud computing providers by eliminating spending on the non-essentials.
With this context, the market had expected DigitalOcean -- a small player -- to do poorly in its latest quarter. These low expectations are evidenced by its price-to-sales (P/S) valuation. In October, DigitalOcean stock hit a P/S ratio of 3, its cheapest valuation since going public in 2021.
DOCN PS Ratio data by YCharts
However, DigitalOcean reported Q3 financial results on Nov. 2 and shocked the market. In Q3, the company grew revenue 16% year over year to $177 million. On one hand, this was its slowest growth rate as a public company. On the other hand, management had guided for Q3 revenue of $174 million at best.
Therefore, DigitalOcean outperformed guidance, which the market didn't believe was possible in the current environment. Given how far its stock had fallen, even a modest beat was enough to generate outpaced returns.
Lenschow had lowered his price target for DigitalOcean in part because he didn't believe the market would react positively to anything in the software space this quarter. But the market apparently will react to a company beating its own guidance while trading at an all-time low valuation.
Is the market too optimistic now?
Relative outperformance doesn't necessarily mean that things are great for DigitalOcean right now. In the upcoming fourth quarter, management is targeting revenue of $178 million. That's up only $1 million sequentially. And it's up only 9% year over year, which represents a new low for its growth rate.
Growth is slowing for DigitalOcean, so a lower valuation is justified. Moreover, the company is looking for a new CEO to replace its current CEO, Yancey Spruill. For his part, Spruill has always emphasized free-cash-flow growth and has delivered. But there's no way to know what a new CEO would prioritize.
With slowing growth and uncertainty with leadership, DigitalOcean stock might be one to watch from the sidelines for now.
