Tesco is to launch a complete overhaul of its supermarkets, including radical curbs on the opening of giant out-of-town superstores, after suffering its worst Christmas in decades.

Nearly £5bn was wiped off the company's stock market value on Thursday after the supermarket juggernaut hit the wall during the peak selling season. The firm has broken 30 years of unchecked financial success with the shock warning that UK profits could fall in the coming year.

The humbling of the supermarket leader was blamed on an exodus to rival chains such as Sainsbury's and Asda during the most important trading weeks of the year. Rivals bombarded shoppers with money off coupons and promotions that overshadowed Tesco's £500m "Big Price Drop", now dubbed the "Big Price Flop" by analysts.

The upset sent shockwaves through the City with the shares closing down 16% – thought to be its biggest one day tumble ever.

In an unprecedented mea culpa, Tesco boss Philip Clarke – who took over from Sir Terry Leahy last year – said the giant store chain had to change and promised to plough millions of pounds into improving the quality of its fresh food, the choice of products it sells as well as its customer service.

"This isn't going to kill us, it is going to make us stronger," he said. The festive hiatus had resulted in a lot of "soul searching" at its Hertfordshire headquarters, he said, but insisted one of the UK's biggest companies was not in crisis: "I feel like I am in control and taking decisions that need to be taken."

Tesco is not the only retailer feeling the strain on the back of the national austerity drive that is the ongoing legacy of the financial crisis. It was a black day for the whole high street as other major store groups including Argos, Mothercare, Halfords and Thorntons all reported sales declines over the crucial holiday season when they usually bank the lion's share of their annual profits.

But investors were most alarmed by Tesco's problems as its 2,715 UK stores are the cash machines that finance its expansion around the globe. The retailer has established chains in far flung locations such as Thailand and the US, but it remains reliant on the success of its UK shops – which generate two-thirds of its near £68bn annual sales and £3.7bn profits.

Before the update investors had expected Tesco's profits to rise 10% in the next financial year but the company said they would now be flat, a situation that analysts said could only reflect a fall in profits at its UK arm. Panmure analyst Philip Dorgan said weakness in Britain could undermine Tesco's expansion in fast-growing markets like China and slashed his forecasts by 15% for the next two years. "This is the nightmare scenario," he said. "If the UK's profits keep falling, then it will not be able to invest so much overseas."

The turmoil sees Clarke start to unpick some of the legacy of his lauded predecessor Leahy. The retailer will open fewer big Extra hypermarkets, which were key to its conquest of Britain's retail sector in the 1990s, in the future. The Tesco chief backed away from labelling its more than 200 out-of-town hypermarkets as "a white elephant" but said they were a "less potent force" and he did not need many more.

The change could signal a turning point in the development of UK retail as in recent years there has been a "space race" among the major supermarkets. Some £5bn has been invested in opening new supermarkets every year.

With the largest non-food business of all the grocers, the flaws in the Tesco business model, which is still being copied by rivals, have been exposed by a savage downturn in consumer spending. The retailer has also been hit by the speed with which clothing and electricals sales are shifting online. The same trend is also behind the precipitous decline of Britain's town centres, where more than one in seven shops is empty.

Tesco was always expected to have a tougher time than its smaller rivals at Christmas because of its large clothing and homeware business, which is the area where shoppers have been cutting back most. But the magnitude of its problems, with Clarke describing recent sales as "below our expectations and disappointing", shocked City retail experts. Underlying sales were down 2.3% in the six weeks to 7 January – far worse than expected and well below the figures already reported by Sainsbury's and Morrisons.

Tesco launched the Big Price Drop last autumn in a bid to reverse falling market share, although it remains twice the size of its nearest competitor Wal-Mart-owned Asda with more than 30% of the UK grocery market.

At that time the retailer, which rakes in more than £1 out of every £7 spent on the high street, said sales would suffer in the short term as extra sales would not offset an immediate drop in cash taken at the till. Some analysts argue, however, that the Big Price Drop backfired because the company axed its popular double ClubCard points offer to pay for it.

Kantar Retail analyst Bryan Roberts said Tesco had been guilty of the kind of "complacency" that had enabled it to overtake former market leader Sainsbury's in the 1990s. "Big Price Drop is clearly not enough to win shoppers. Value is not just about price.

"It is also about standards, service, quality, and freshness and Tesco has been letting all of these slip. The business has not had its eye on the ball, both in the latter stages of the Leahy reign and in the Clarke era too." Clarke said he was addressing "long standing business issues" but refused to criticise Leahy, who transformed the group into the world's third largest retailer during his 14 year reign. "There is no poison chalice," he said.

There was a polarisation of performance in the retail sector over Christmas with the chains that have done well – a list that includes John Lewis and upmarket food retailers Sainsbury's, Waitrose and M&S – tending to be those that offered shoppers the chance to treat themselves after a difficult year for many families.

Neil Saunders, analyst for Conlumino, said Tesco had made a mistake by choosing to fight the Christmas sales battle on low prices alone: "This festive season was not about austerity; consumers were willing to trade up and sought quality and value rather than just low prices. Tesco's marketing and promotion was not positioned to take best advantage of this."

• This article was amended on 13 January 2012. Analyst Bryan Roberts works for Kantar Retail, not Kantar Worldpanel; this has been corrected. The phrase 'and the one after that' has been deleted from the end of the second sentence of the ninth paragraph.