Discussion Paper

Valuation of Hang Seng Bank:

Drivers behind Growth Potential

CHEN Si Ting, Dawn

HU Zhi Jue, Echo
WU Ye Yang, Elaine
ZHANG Lu, Louise

Department of Economics and Finance, Faculty of Business

City University of Hong Kong

January 16, 2007

 Valuation of Hang Seng Bank:
Drivers behind Growth Potential

Contents

Abstract 2
_____________________________________________________________________________

1 Introduction 3
_____________________________________________________________________________

2 Key Assumptions
2.1 Loan Growth and Net Interest Margin 5
2.2 Net Interest Income Growth 6
_____________________________________________________________________________

3 Catalyst 1 – Opportunities in China Market

3.1 Strong Growth in CIB Profit 7
3.2 Investment in Mainland Outlets 8
_____________________________________________________________________________

4 Catalyst 2 – Continued Growth on Property Gains

4.1 Property Revaluation Gains 9
4.2 Mortgage in Residential Markets 9
_____________________________________________________________________________

5 Catalyst 3 – Strong Growth in Non-Interest Income

5.1 Strong Growth in Insurance Income 10
5.2 Great Potential in Credit Card Service 10
5.3 Operating Expense 10
_____________________________________________________________________________

6 Valuations
6.1 Dividend Discount Model 11
6.2 P/B Ratio Valuation 13
_____________________________________________________________________________

7 Conclusion 15
_____________________________________________________________________________

Appendix I Hang Seng Bank: Key Financial Data 16

_____________________________________________________________________________

Appendix II Business Performance 18

_____________________________________________________________________________

Appendix III Competitive Analysis 18

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 Valuation of Hang Seng Bank:
Drivers behind Growth Potential

Valuation of Hang Seng Bank:

Drivers behind Growth Potential

Abstract

This report presents two valuation models capturing growth drivers of Hang Seng
Bank (“HSB”) stock 1 to project its future performance based on annual time series
data from FY2000 to 1H2006. The Dividend Discount Model in this report is
determined by constant growth model; and the P/B ratio model is used to compare
the stock performance of HSB to the overall Banking sector in Hong Kong.

Given the improving economic environment in Hong Kong, our assumptions are
mainly based on the public information of HSB as reflected in its annual reports,
investor relations news and overall economic picture. The outlook of the future
development is also based on our interview of HSB’s CFO, Mr. Patrick Chan. Thus we
have a rather strong information source to support our valuation and forecast.

Analysis and estimates of the stock performance of HSB is briefly introduced in this
report from three perspectives: China Market, Property Revaluation and Mortgage
in Residential Markets, and finally Non-Interest Income. The focus of this report is
the stock valuation in light of the above estimates of HSB, which may provide a
strong guide for investors to make their decisions.

1
Reuters: 0011.HK; Bloomberg: 11.HK

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 Valuation of Hang Seng Bank:
Drivers behind Growth Potential

1 Introduction

Hong Kong, as an international finance and business center, is attracting increasing

investors from all around the world. As a city of life, Hong Kong is also the freest
economic district in the world. Therefore, our interest in Hong Kong’s banking
sector as well as the individual stock of HSB arises here from its world reputation.
What determines the stock price of HSB in Hong Kong? How would the future
development strategies influence its stock performance when overall economic
environment change? Basing on these questions, we start our research in the
aspect of the valuation of HSB’s stock.

Founded in 1933, Hang Seng Bank is Hong Kong’s largest locally incorporated bank
in terms of market capitalization. It has a significantly good reputation and
branding name for the public. Furthermore, for HSB to expand its insurance
services, it has a wide customer base which is the fundamental basis for its future
strategic services expanding insurance that will be more company cost efficient
than other financial institutions and wealth management.

Continued growth in the number of high net worth individuals is pushing the
demand for wealth management services. In order to capitalize on this trend, the
company is offering investments in various asset classes to suit the risk/return
appetite of its customers. With its expertise in providing innovative wealth
management solutions, the company expects to significantly enhance its assets
under management.

Not only is HSB the largest locally incorporated bank in HK on the basis of market
capitalization, it has emerged as the one of the major players in the mainland China
with the acquisition of 15.98% interest in Industrial Bank of China (CIB). It
operates more than 145 branches and automated banking centers in Hong Kong; a
branch in Macau; and a network of 14 mainland China outlets, including six
branches (in Beijing, Shanghai, Guangzhou, Shenzhen, Fuzhou and Nanjing), six
sub-branches (four in Shanghai, one in Guangzhou and one in Shenzhen) and two
representative offices (in Xiamen and Dongguan). HSB has received approval for a
foreign exchange conversion limit of USD300 million for its QDII (Qualified
Domestic Institutional Investor) services, which will enable the Bank to provide
Mainland enterprises and residents with overseas wealth management services.

Competition in the banking sector of Hong Kong will remain fierce in the next few
years. HSB will further build its capabilities in areas such as wealth management,
small and medium-sized enterprise services and consumer lending that offer good
growth prospects. Moreover, it will continue to expand its Mainland business and
investment in its staff, brand and delivery channels. It will enhance its product and
service offerings, which will enable HSB to build on the progress and deliver
increasing value for shareholders.

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 Valuation of Hang Seng Bank:
Drivers behind Growth Potential

SWOT Analysis

Strengths – Market leadership

HSB is largest locally incorporated bank in HKSAR on the basis of market
capitalization. With the acquisition of 15.98% interest in CIB, HSB has emerged as
the one of the major players in the mainland China.

Weaknesses – Increasing operating cost in the Mainland China

HSB is expanding the business in Mainland China. In the coming 2006 to 2008, it
plans to invest over HK$1billion in the Mainland to expand the service capabilities
and network of outlets to more than 30. The employee headcount will also increase
significant. This will drive the operating cost into further upwards.

Opportunities – Wealth management services

Continued growth in the number of high net worth individuals is pushing the
demand for wealth management services. In order to capitalize on this trend, the
company is offering investments in various asset classes to suit the risk/return
appetite of its customers. With its expertise in providing innovative wealth
management solutions, the company expects to significantly enhance its assets
under management.

Threats – Spread shrinkage

The mortgages issued at ultra-low rates at the beginning of the 2005 have turned
into money-losing proposition for banks in Hong Kong, which are paying heavy
interests for funds borrowed on the inter-bank market. These mortgages have
turned into a losing proposition for the banks. This asset-liability mismatch can
adversely affect the company’s earning capacity, thereby resulting in a margin
contraction.

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 Valuation of Hang Seng Bank:
Drivers behind Growth Potential

2 Key Assumptions

2.1 Loan Growth and Net Interest Margin

The loan growth projection is based on our industry loan growth assumption of 6%.
It is believed that 6% industry loan growth is fair because Hong Kong’s average
loan growth has been 0.96x nominal GDP growth since 1990. Based on this past
experience and sustainable GDP growth of 6% over the next few years, 6%
industry loan growth assumption is reasonable. And HS will undergo a slow loan
growth rate in 2006 but it is probable that it will speed up in the near future.

HSB’s 1H06 loan growth may seem unsatisfactory with a mere 2.17% compared to
a higher industry growth of 4.27% for the licensed banks in HK. This was mainly
due to the fierce competition in the mortgage markets among the banks. The
mortgage is now comprised around 40% of the total gross advances to customers,
with which somehow limit the further growth of the Group. But we expect it to catch
up the industry growth rate in the near future mainly from loans to customers in the
Mainland and the trade finance sector.

Although Mainland Expansion is just at the start stage of the whole plan, the
promising future growth can already be seen from its 42% loan growth in 2005,
followed by a 21.7% growth in the 1H06. Based on this trend an estimation of a
constant loan growth rate of 30% for the rest of the year is expected.

In addition, a recovering trend occurred in the trade area since the beginning of the
year, as in August 2006, the volume of Hong Kong's re-exports of goods increased
by 11.5% over August 2005 and the volume of total exports of goods increased by
10.2%, which resulted in a relatively high growth of 19.49% and up-warding trend
in the coming years.

Our general assumption is that the total loan growth of HSB will sustain at a pace
between 4-6%. The earnings forecasts are based on the following key assumptions:
Net Interest Margin will peak in 2006 and show a downward trend from 2007;
prime lending rate of 7-7.75% of 2006-08F; provisions rate rising 1% each year.

Figure 1 Net Interest Margin

2.35%
2.33% 2.32%
2.30% 2.30%
2.25%

2.20% 2.19%
2.15%

2.10%
2.08%
2.05%

2.00%

1.95%
2004 2005 2006F 2007F 2008F

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 Valuation of Hang Seng Bank:
Drivers behind Growth Potential

2.2 Net Interest Income Growth

We can expect a solid growth in HSB’s interest income, as it has already been
proved by the strong interest income growth over 1H06 (19.8% hoh and 68.8%
yoy). However, the interest rate is about to fall since HSB has lowered its prime rate
from 8% to 7.75% recently. In conclusion, we assume that the net interest income
growth will be 12.9% in FY06 and dropped to 10% in FY07. The following table
captures the key assumptions of HSB in this report:

Table 1 Key Assumptions

% 2004 2005 2006F 2007F 2008F
Net interest margin 2.1 2.2 2.2 2.2 2.0
Cost/income 0.80 0.80 1.30 1.40 1.50
Provision/avg loans -0.31 -0.24 0.29 0.36 0.39
Current deposit growth 8.0 5.9 9.0 9.0 9.0
Savings deposit growth 56.0 41.4 40.0 40.0 40.0
Loan growth 5.5 6.8 3 4 6

Interest rates
3M HIBOR 0.46 3.11 4.20 3.90 3.70
Prime 5.00 6.28 7.75 7.25 7.00
UST 2Y 2.35 3.85 4.85 3.90 4.90
Data Source: Merrill Lynch Forecast Committee & CityU Estimates

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 Valuation of Hang Seng Bank:
Drivers behind Growth Potential

3 Catalyst 1 – Opportunities in China Market

Figure 2 The Contribution of Profit from the Mainland Business

Segmental Analysis (by Geographical Segmental Analysis (by Geographical

Region) in 2004 Region) in 1H2006

Americas Americas
12% 7%
Hong Kong
Hong Kong
89%
87% Mainland
Mainland and other
and other 4%
1%

Hang Seng’s mainland China business forms an increasingly important part of its
long-term growth strategy. Accelerating liberalization in the financial sector, strong
economic growth trends and the Mainland’s close relationship with Hong Kong are
providing us with increasing opportunities for new business. As Figure 9 indicates,
the profit from the mainland China play an more important role from segmental
view as the contribution from it increased from just 1% to 4% in 2 years.

3.1 Strong growth in CIB profit

Figure 3 Share of Profit from Industry Bank

1200 100%

1000
80%

800 Share of profits

from Industrial
60%
Bank
600
Percentage of
40% profits from
400 associates

20%
200

0 0%
2005 2006F 2007F 2008F

Data Source: CityU Estimates

Hang Seng currently holds 15.98% of CIB. In 2005, the investment in CIB has
brought HSB a profit of 358 million RMB and in the 1H06 the profits was up 10% at
HK$209 million. It’s expected net profit for CIB to grow 40% for FY06 to FY07. CIB
will contribute RMB487, RMB681 and RMB954 respectively to HSB from FY06 to
FY2008. It is also worth noticing that based on our projection; the percentage of
the shares of profits from CIB is also increasing from 71% to 95% in terms of the
total shares of profits from associates, which is a positive sign for HS to achieve its
10% contribution goal.

On the other hand, HSB has stated its intention to increase its stake in CIB, if the

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 Valuation of Hang Seng Bank:
Drivers behind Growth Potential

regulators will relax the restrictions on foreign ownership of domestic banks. HSB’s
profit could be further boosted if this turns out to be true. And Mr. Patrick Chan also
mentioned that the Group will seek further acquisition opportunities to invest in
banks that are performing steadily well, such as CIB.

HSB has a mission plan to achieve 10% mainland profit contribution of total
operating profit in next 5 years. This is mostly from the net profit of CIB, which is
expected to grow 40% for FY06 to FY07.

CIB had applied to the Chinese securities regulator for a domestic IPO listing long
ago. So it is highly possible for CIB to be listed in Shanghai although it had been
delayed to the end of the next year. And we believe the amount gained from the
issuance will exceed 10 billon RMB (US$1.25 billion), based on the bank’s total
equity of 12billion RMB (US$1.514 billion), an 8.18 per cent capital adequacy ratio
at the end of 2005.

3.2 Investment on mainland will bring profit

Apart from CIB, Hang Seng also operates 15 outlets in the mainland. The “one year,
one Branch” expansion strategy is being implemented as the management aims to
double the number of outlets within 5 years. Hang Seng will spend HK$1b between
2006 and 2008 to reach this goal. But there will be no pressure for capital as the
bank had issued US$450m of 10-year subordinated debt. Although the amount
spent in China till now remains in an investment phase, the loans service does show
an outstanding performance with 42% loan growth in 2005 and 21% in 1H06. We
expect the trend on loan growth in China to remain strong at a 25% growth. Also,
Hang Seng is going to incorporate in China, and offer retail RMB services. As a
result, it’s estimated the profit forecast for FY07 to be HK$12,521m.

Table 2 Assumptions for Share of Profits from Associates

Growth Rate
2004 2005 2006 2007 2008
Profit for the year 70% 47% 40% 40% 40%
Profit attributable to shareholders 70% -19% 36% 40% 40%
Share of profits from CIB 36% 40% 40%
Share of profits from associates (HK $) 10% 30% 40%
Data Source: CityU Estimates

We expect the trend on loan growth in China to remain strong at a 25% growth.
Also, Hang Seng is going to incorporate in China, and offer retail RMB services. As
a result, we estimate the profit forecast for FY07 to be HK$12,521m.

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 Valuation of Hang Seng Bank:
Drivers behind Growth Potential

4 Catalyst 2 – Continued Growth on Property Gains

HSB’s net profit of HK$6,190m in 2006 was supported by property gains (HK$766m)
which come from the net surplus of the property revaluation and sales of its office
building. The sustained gains on property revaluations are due to HSB’s Property
Portfolio Rationalization Programme to expand its capital for future business
expansions.

4.1 Property Revaluation Gains

The total property revaluation gain for HSB in 2005 is HK$318m, a result of the sale
gains of its office building next to HSB’s headquarters of the HK$448m. Thus we
think the market will have an upward forecast for FY06 thanks to the disposal gains.

HSB has a long-term property portfolio rationalization programme which will

enable HSB strategically expand its capital in terms of property revaluations and
investment. Furthermore, the programme will improve HSB tier 2 capital as the
property revaluation reserve to fully support HSB’s future business growth.

4.2 Mortgage in Residential Markets

As the nature of mortgage lending in Hong Kong property market has relatively
lower risk, given the same rate of return due to its high-quality collaterals, the loan
impairment is also low. HSB’s mortgage loans account for 40% of the Bank’s loan
book; it can guarantee the steady loan growth to some extent.

We believe the mortgage, especially in residential markets, will help HSB to keep
provision charge low. Besides, to respond to the keen mortgage price war among
the peers, on average, HSB priced its mortgage portfolio at 230bps below PRIME in
1H06 versus 223bps below PRIME in 1 H05. Furthermore, due to HSB’s strategic
planning in investing in the Mainland market, the promising mortgage lending will
also be a large potential catalyst to improve the general performance of HSB.

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 Valuation of Hang Seng Bank:
Drivers behind Growth Potential

5 Catalyst 3 – Strong Growth in Non-Interest Income

5.1 Strong Growth in Insurance Income

As Figure 5 shows, the industry non-linked life insurance is increasing by 17% in

2005, and HSB’s non-linked insurance premium increases with the same trend as
industry. Insurance income as a major profit driver and the non-linked insurance
premium is expected to rise by 50% in average for the next two years.

Figure 5 Insurance Premium of Industry and HSB

120000

100000

80000

60000

40000

20000

0
2002 2003 2004 2005 2006F 2007F 2008F

Industry Hang Seng Bank

5.2 Great Potential in Credit Card Service

Credit Cards service is expected to be another driver for non-interest income. In

the last two years, the income from Credit Cards recorded 8.5% and 17.9%
increasing in 2004 and 2005 respectively. The net insurance premium and fee
income from credit cards are 65.67% and 7% respectively of up non-interest
income. The high growth rate of these two businesses would push the non-interest
income. Based on the above, we expect the non-interest income growth will
be34%% and 20% for 2006 and 2007.

5.3 Operating Expense

HSB continues to invest with 2.14% expenses down hoh in 1H06 but 8.4% up yoy
from 2005 to 2006. The investment is mainly allocated in promoting the wealth
management services, commercial banking and China market. Comparing to the
increasing operating income, the cost efficiency ratio is expected to maintain at a
low level 28.5% in 2006 and 27% in 2007.

Table 3 Operating Expense

Expenses (HKD m) Growth (%)
2003 2004 2005 2006F 2007F 2008F
Employee compensation and
2043 2234 2281 3.9% 4.2% 4.8%
benefits
General and administrative
1530 1734 1976 10.3% 9.5% 8.1%
expenses
Total operating expense 3902 4232 4546 5.3% 6.0% 5.4%

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 Valuation of Hang Seng Bank:
Drivers behind Growth Potential

6 Valuations

We believe that HSB is undervalued. Based on the DDM model, we initiate with a
target price of HK$115.1. Moreover, HSB has a high P/B relative to its peers due to
a sustainable high ROE.

6.1 Dividend Discount Model

Since Hang Seng has been paying out a dividend every year, and the growth trend
along the years is quite sustainable, so we decide to derive the target price of Hang
Seng Bank in 2007 based on the constant growth DDM model to derive the target
price and also complemented it with a comparison of the PB among different banks.

Table 4 Dividend
2003 2004 2005 2006E 2007E 2008E
Profit attributable to
9,539 11,364 11,342 11936 12224 12560
shareholders
EPS 4.99 5.94 5.93 6.24 6.39 6.57
DPS 4.9 5.2 5.2 5.2 5.5 5.6

Dividends 9368 9942 9942 9942 10515 10706

Pay out ratio 98.2% 87.5% 87.7% 86.50% 84.46% 85.24%
1-Pay out ratio 1.8% 12.5% 12.3% 13.50% 15.54% 14.76%

Growth Rate 0.42% 3.51% 3.34% 3.76% 4.36% 4.19%

Based on our forecast of a quite sustainable ROE around 30% and dividend payout
ratio around 80%, we assume the growth rate from 2006 onwards to be 6% per
year. We derive our required rate of return based on the CAPM model. We find the
above variables in Bloomberg, which is 3.84% for risk-free rate, 0.59 for the Beta
of Hang Seng, and 5.58% for the Market Premium of the industry. Given the
variables, we get a required rate of return of 8.36%.

Table 5 CAPM Model Assumptions

Beta 0.56 0.57 0.58 0.59 0.60 0.61 0.62
Expected Market Return 11.50 11.50 11.50 11.50 11.50 11.50 11.50
Risk-free rate 3.84 3.84 3.84 3.84 3.84 3.84 3.84
HSB Cost of Equity 8.13 8.21 8.28 8.36 8.44 8.51 8.59

λ Expected risk-free rate of 3.84% and required rate of return of 8.36%.

λ Growth Rate (g) = Retained Ratio * ROE = (1- Dividend Payout Ratio) * ROE

λ Required Rate of Return (k) = Risk-free rate + Beta of HS * Market Premium

= Risk-free rate + Beta of HS * (Market Return – Risk-free Rate)

λ P = D1 / (k– g) = D0 * (1 + g) / (k - g)

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 Valuation of Hang Seng Bank:
Drivers behind Growth Potential

The sensitivity analysis table below shows a sensitivity of the price towards various
risk premiums of Hong Kong and our estimated growth rate. We expect the risk
premium to be 8.28%, and a terminal growth rate of 3.76% and therefore reach a
target price of $119.37.

Table 6 Sensitivity Analysis

Cost of Equity
Growth Rate 7.50% 8% 8.28% 8.50% 9%
3.00% 119.02 107.12 101.44 97.38 89.27
3.30% 127.90 114.29 107.86 103.30 94.24
3.60% 138.13 122.44 115.11 109.94 99.76
3.76% 144.27 127.25 119.37 113.83 102.97
3.90% 150.08 131.78 123.35 117.45 105.94
4.20% 164.19 142.59 132.80 126.01 112.88
4.36% 172.83 149.09 138.44 131.08 116.96
4.50% 181.13 155.26 143.76 135.85 120.76
Data Source: CityU Estimates

Based on the peer comparison and dividend discount model, it seems the result is
too optimistic, as a little change in growth rate will result in great change in price,
so we choose to be prudential on the future growth of HSB and takes $115.11 as
our final target price. This result is also reflected in the following table of sensitivity
analysis of stock prices based on cost of equity from 8.05% to 8.44% and dividend
growth from 3% to 4%. We could see that the range from 113 to 117 has the
highest profitability, showing that our target price of $115.11 is reasonable.

Figure 6 Normal Distribution of HSB Price

18%

15%

12%

9%

6%

3%

0%
97-101 105-109 113-117 121-125 129-133 137-141
Price of HSB (HK$)

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 Valuation of Hang Seng Bank:
Drivers behind Growth Potential

6.2 P/B Ratio Valuation

HSB’s P/B stands within the highest level in the sector or compared to the Hong
Kong financial stock market, and we believe the high P/B of HSB is supported by
the following three reasons:

Table 7 Valuation Composition - Hong Kong Financial Sector

P/B (x) Yield (%) ROE (%)
FY06F FY07F FY06F FY07F FY06F FY07F
Banks: 4.63 4.66 5.23 5.23 27.87 28.07
HSB 2.38 2.36 3.85 4.12 17.775 17.699
HSBC 2.31 2.33 3.53 3.5 11.98 11.78
Bank of East Asia 2.33 2.29 5.06 5.04 18.24 18.09
BOC Hong Kong 1.52 1.50 4.18 4.10 10.65 11.12
ICBC (Asia) 2.63 2.64 3.20 3.4 17.17 17.09
Wing Hang Bank 1.64 1.67 4.02 3.99 11.25 10.99
Wing Lung Bank 1.78 1.78 3.80 3.91 11.96 11.06
Dah Sing Bank 1.23 1.26 3.66 3.59 6.99 6.97
Liu Chong Hing Bank 2.31 2.33 3.53 3.5 11.98 11.78
LCH Bank 2.33 2.29 5.06 5.04 18.24 18.09
Fubon Bank 1.52 1.50 4.18 4.10 10.65 11.12

Financial sector:
HKEx 16.57 16/45 2.32 2.29 30.67 30.65
CITIC Int.Fin.HDG. 1.91 1.92 2.19 2.06 12.41 12.12
Dah Sing Fin. HDG. 1.83 1.81 3.12 3.11 11.76 11.74

Blue chip market:

Overall 1.14 1.137 1.98 0.99 6.47 6.98
Financial sector 1.27 1.26 2.12 2.18 12.59 12.09

λ High and sustainable ROE

On 4.66 xFY07F book values, HSB is certainly not cheap, but we believe this
strongly supported by its absolutely high 28.07% ROE, and given the analysis
above, we expect that the high ROE will be high and sustainable in 2006-2008.

λ Sustainable DPS
HSB’s dividend yield of 5.23% is the highest in Hong Kong banking sector as
well as the entire financial sector, and also 164% higher than the average yield
for the blue chips.

λ Good management quality

Founded in 1933, Hang Seng Bank is Hong Kong’s largest locally incorporated
bank in terms of market capitalization. It has a significantly good reputation and
branding name for the public. Furthermore, as HSB is respected in the wealth
management services, it has a wide customer base which is the fundamental
basis for its future strategic services expanding that will be more cost efficient

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 Valuation of Hang Seng Bank:
Drivers behind Growth Potential

than other financial institutions and wealth management firms. As the

subsidiary of HSBC, the company management quality is strong assured.

Figure 6 ROE vs. P/B

30.00 28.07

25.00

20.00
14.25
15.00

10.00
4.66
5.00 2.20

0.00
H SB H SBC BE A BO C H K I C BC WH B WL B D ah Sing LC H C ITIC D ah Sing I ndus try
(A s ia) Fin. A verage

ROE P/B (x)

Provisions are a significant uncertainty and swing factor for HSB’s earnings. We
show below our estimates of how higher and lower provision charges will impact
HSB’s earning and ROE. We use FY07F earnings for stress testing because we
believe the chances of higher-than-expected provisions will be greater in 2007 than
in the near term, i.e., 2006. Basically, every 4 bp increase in the provision charge
will reduce ROE by 8bp.

Table 8 Sensitivity Analysis of ROE to Provision - FY07F

(Assumption: 2003-basis year)
Provision charge
20 24 28 32 36* 40 44 48 100
(bp loans)
Provision charge
563 675 788 900 1,013 1,125 1,238 1,350 281,351
(HK$ m)

yoy growth (%) (29.0) (14.7) (0.5) 13.7 27.9 42.1 56.3 70.5 354.2

Stated net profit

12781 12683 12585 12487 12389 12291 12193 12095 10822
(HK$ m)

yoy growth (%) 31.6 30.6 29.6 28.5 27.5 26.5 25.5 24.5 11.4

adj. ROE 28.95 28.73 28.51 28.29 28.07 27.84 27.62 27.4 24.5

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 Valuation of Hang Seng Bank:
Drivers behind Growth Potential

7 Conclusion

We expect HSB to catch up the industry growth rate in 2008. Constant growth rate
will be 30% in 2007 and 2008 for the mainland loans. For trade finance sector,
there is a 19.49% loan growth from 1H05 to 1H06. We estimate a 3% loan growth
rate in 2006 and 4-6% afterward.

For the opportunities in Mainland market, HSB has a mission plan to achieve 10%
mainland profit contribution of total operating profit in next 5 years. Net profit from
CIB is expected to grow 40% for FY06 to FY07. There is great potential for HSB IPO
listing in Shanghai at the end of 2007 and gains are estimated to be 10 billion RMB.

There will be sustained gains on property revaluations due to Property Portfolio

Rationalization Programme. The risk for HSB in mortgage market is low with
high-quality collaterals. The mortgage loans in the expanding China market will
grow in the next three years.

Insurance income as a major profit driver and the non-linked insurance premium is
expected to rise by 50% in average for the next two years. As another driver for
non-interest income, we expect the income growth from Credit Cards will be 8.6%
in 2006 and 2007. Cost efficiency ratio keeps low under the 30%level. We are
assuming a slight NPL growth of 4%pa, which translates into moderate rise in loan
impairment in FY06-08F.

To sum up, Hang Seng Bank has been consistently trading at premium valuations
over its peers in the local market, which are considered well justified by its
excellent operating record and prudent management. The ongoing recovery of the
local economy will definitely benefit the bank as it has been an outperformer in the
loan market and should remain so ahead with its excellent services. Having
established its China presence as far as in 1985, when the first representative office
was opened in Shenzhen, HSB has taken advantage of the relaxation on foreign
ownership in Mainland banks by acquiring a 15.98% interest in Industrial Bank for
Rmb1.7b late last year, which was the largest ever acquisition made by a foreign
bank since the market was opened.

Our dividend discount model suggests that HSB should be worth $115.11 per share
in the year 2007, based on a required rate of return of 8.28% p.a. and a perpetual
growth rate of 3.6% p.a.

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 Valuation of Hang Seng Bank:
Drivers behind Growth Potential

Appendix I Hang Seng Bank: Key Financial Data

Income Statement
YE DEC (HK$ m) 2003 2004 2005 2006E 2007E 2008E
Interest Income 12846 12782 19029
Interest Expense (2667) (2777) (7961)
Net Interest income 10179 10005 11068 12496 13745 15120
Non-interest income 5198 9820 12178 16319 19582 21540
Total operating income 15377 19825 23246 28814 33328 36660
Net insurance claims 0 (3772) (7014) (7343) (9791) (11847)
Operating income before provision 15377 16053 16232 21471 23536 24813
Loan loss Provision expense (792) 777 (618) (797) (1013) (1124)
Operating expenses (3902) (4232) (4546) (8212) (8998) (9898)
Operating profit 10683 12598 11068 12462 13525 13791
Income from associates 30 97 500 550 715 1001
Non-recurring 424 588 1790 940 0 0
Pre-tax Profit 11137 13283 13358 13952 14240 14792
Tax (1423) (1711) (1795) (1814) (1851) (1923)
Profit after tax 9714 11572 11563 12138 12389 12869
Minorities (175) (208) (221) (202) (165) (309)
Attributable profit 9539 11364 11342 11936 12224 12560

Balance Sheet (HK$ m)

YE DEC (HK$ m) 2003 2004 2005 2006E 2007E 2008E
Cash & interbank 89932 82327 78487 99764 104434 109322
Total loan assets 229466 251553 260680 274757 281351 289791
Investments in securities 143796 186390 197646 220985 219854 220220
Tangible assets 9565 8941 11023 9964 12131 14769
Investment in associates 549 2299 2929 3074 3219 3364
Trading assets 0 4232 12600 13316 14130 14994
Intangible assets 0 1266 1636 1863 164 14
Other assets 29651 9939 15819 9824 9047 8331
Total assets 502959 546947 580820 633547 644330 660805
Customer deposit & CDs 439913 463515 441018 464832.97 475988.96 490269
Deposits from banks 1202 11934 12043 21667 21124 20702
Trading liabilities 0 5840 45804 60225 58342 60000
Subordinated debts 0 0 3511 6000 6041 6000
Others 21559 23877 34714 37455 37917 38000
Total Liabilities 462674 505166 537090 590180 599413 614971
Share holders' fund 39641 40929 42571
Minority interest 644 852 1159
Total equity 40285 41781 43730 43367 44917 45835
Non-performing loan
Loan Impairment -792 777 618 -797 -1013 -1124

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 Valuation of Hang Seng Bank:
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Cash Flow Statement

YE DEC 2003 2004 2005 2006E 2007E 2008E
Per share ratios
EPS (HK$) 4.99 5.94 5.93 6.24 6.39 6.57
EPS growth -3.84% 19.13% -0.19% 5.28% 2.41% 2.75%
P/E(x) 19.93 16.73 16.76
BVPS ($) 20.73 21.41 22.27 22.68 23.49 23.97
PBV(x) 4.8 4.65 4.47
ROE 23.06% 28.21% 27.17% 27.87% 28.07% 28.36%
ROA 1.99% 2.20% 2.05% 2.30% 2.23% 2.27%
DPS (HK$) 4.9 5.2 5.2 5.4 5.4 5.6
Dividend Yield 4.93% 5.23% 5.23%

Earnings and Forecasts

YE DEC 2003 2004 2005 2006E 2007E 2008E
Net profit (HKD m) 9539 11364 11342 11936 12224 12560
Net interest income growth -5.80% -1.70% 10.60% 12.90% 10% 10%
Non-interest income growth 21.40% 88.90% 24% 34% 20% 10%
Operating cost/assets 0.80% 0.80% 0.80% 1.30% 1.40% 1.50%
Cost/income ratio 25.40% 24.60% 28% 28.50% 27% 27%
Non-interest inc/Tot operating income 33.80% 49.50% 52.40% 57% 63% 65%
Customer loan growth 2.20% 9.60% 3.60% 3% 4% 5%
Customer deposit growth 6.30% 1.70% -3.70% 5.40% 2% 3%
Customer LDR 52.16% 54.27% 59.11% 59.11% 59.11% 59.11%
Total LDR 52.02% 52.91% 57.54% 56.48% 56.60% 56.71%
Asset yield 2.87% 2.66% 3.77% 5.03% 6.00% 6%
Funding cost 0.66% 0.66% 1.82% 3.18% 3.50% 3.80%
Interest spread 2.21% 2.00% 1.95% 1.85% 2.50% 1.70%
Net interest margin 2.28% 2.08% 2.19% 2.30% 2.20% 2.00%

Asset quality
YE DEC 2003 2004 2005 2006E 2007E 2008E
NPL amount (HKD m) 5,243 1,793 1,433 1,631 1,701 1,775
NPL ratio 2.26% 0.71% 0.55% 0.59% 0.60% 0.62%
Coverage on NPL 15.11% -43.34% 43.13% 48.87% 59.55% 63.32%
Provision charges (HKD m) -792 777 618 -797 -1013 -1124
Provision charges/tot loans 0.35% -0.31% -0.24% 0.29% 0.36% 0.39%

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 Valuation of Hang Seng Bank:
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Appendix II Business Performance

Operating Expense of HSB

Growth (%) Mixed (%)
2005 2006F 2007F 2008F 2005 2006F 2007F 2008F
Headcount in HK 7,524 2.7% 2.7% 2.7% 93.5% 91.9% 90.0% 87.7%
Headcount in Mainland 521 30.0% 30.0% 30.0% 6.5% 8.1% 10.0% 12.3%
Implied wage level in HK 0.4% 0.4% 0.4%
Implied wage level in Mainland 15.0% 15.0% 15.0%
Employee compensation and benefits 2281 3.9% 4.2% 4.8%

Operating Profits of CIB

Growth Rate
2004 2005 2006E 2007E 2008E
Profit for the year 70% 47% 40% 40% 40%
Profit attributable to shareholders 70% -19% 40% 40% 40%
EPS -15% 118% 31% 50% 17%
ROE
Share of profits from CIB Co. Ltd 36% 40% 40%
Share of profits from associates (HK $) 10% 30% 40%

Appendix III Competitive Analysis

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 Valuation of Hang Seng Bank:
Drivers behind Growth Potential

Reference

1. Hang Seng Bank Annual Report 2005

2. Hang Seng Bank Interim Report 2006

3. Applied equity analysis : stock valuation techniques for Wall Street

professionals by James R. English. McGraw-Hill

4. The bank valuation handbook : a market-based approach to valuing a bank by

Hazel J. Johnson. Chicago, Ill. : Irwin Professional Pub

5. Corporate Finance by Ross, Westerfield and Jaffee, seventh edition, McGraw

Hill.

6. Financial Statement Analysis and Security Valuation by Stephen Penman,

Second Edition, McGraw Hill.

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