Tough economic environments often steer the market away from ASX growth shares and towards their dividend-paying cousins. And, boy, have there been some high-yielding ASX dividend shares this year.
My Fool colleague Bronwyn recently dove into the highest yields among S&P/ASX 200 Index (ASX: XJO) dividend payers in the September quarter – finding some come in at more than 15%.
No doubt that likely turned investors' heads. Particularly, as capital gains have been harder to come by this year.
The All Ordinaries Index (ASX: XAO) has fallen more than 11% so far in 2022, while the ASX 200 has dumped around 10%.
But seeking out huge dividend yields is generally not the best way to build passive income. Keep reading to learn why.
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Why high yields don't always equal passive income
Listed companies pay their shareholders dividends for a variety of reasons. However, the most common payout represents a portion of a company's profits for a particular period.
If a company's profits suddenly soar – as did New Hope Corporation Limited (ASX: NHC)'s in financial year 2022 – they might pay out a notable dividend.
New Hope's most recent final dividend represented a 343% year-on-year increase after its after-tax profit rocketed 1,138% to $983 million. That means the ASX 200 share is currently trading with a 13.4% trailing dividend yield.
Whether that's sustainable is yet to be seen.
And that points to why investing in high-yielding ASX shares might not be the best way to build passive income.
Passive income, by definition, is sustainable over the long term without the need for serious intervention. Generally, high yields are hard to sustain.
I think an investor building a portfolio for passive income should ensure the companies they're investing in can continue to pay notable offerings.
In some cases, a company's profits are linked to an uncontrollable factor. For instance, New Hope's revenue is tied to coal prices.
Other times, there's just not enough headroom between a company's dividend offerings and its net profits.
I would also be wary of a company that pays out nearly all of its profits to shareholders, unless they have a substantial cash balance ready to be employed in tough times.
Additionally, if a company has both a large debt balance and dividend yield, I would want to know why it's not managing debt before paying shareholders.
Finally, when hunting for ASX dividend-paying shares, I'd consider their history.
If a company has long traded on a high yield while managing its balance sheet, that's a positive sign that management might continue prioritising dividends.
If not, it might be worth seeking out dividend shares offering lower, more reliable payouts to help build passive income.
Searching for ASX dividend shares to buy
In my opinion, searching for dividend shares is very similar to hunting out future gainers.
A reliable ASX dividend share generally needs to be able to grow its profitability in order to grow its payouts.
I would personally look for strong businesses with good strategies and competitive advantages when building a portfolio for passive income. Though, there are many other ways to determine if a company is worth buying.
And, as always, I'd search for such companies across a variety of sectors so to diversify my portfolio.
